The Case of Online Tax Filing

This exerpt from Digital Government: Technology and Public Sector Performance, examines online tax filings in e-government.

by / February 9, 2006
Editor's note: We all know that e-government was supposed to transform the public sector. Although it hasn't worked out that way, that doesn't mean online service delivery won't have an impact on government performance, the political process, or even on democracy, according to author and scholar Darrell M. West. In this excerpt from his new book, Digital Government, West examines how online tax filings have come to represent the promise and peril of e-government today.

Nothing illustrates the opportunities and challenges of technological change more than the subject of electronic services. Public officials have placed a high priority on getting services online. Consistent with technocratic vision aimed at the business community and middle class, the goal of many city, state and federal planners is to allow Internet users to register cars, file for business permits and pay taxes online, among other features. Professional associations of IT experts are pushing for these options, and elected officials have embraced Internet service delivery as a long-term objective.

There are several reasons for this focus on service delivery. The first is budgetary in nature. Services are an expensive part of government agencies. This is the feature of the public-sector mission that requires office space, financial resources and staff. Since services are expensive to provide in person and over the telephone, government officials hope that electronic delivery will lower the cost of service delivery, thereby saving the government money. If usage levels rise and people make more extensive use of online services, government agencies can redirect staff, office space and financial resources from in-person service delivery to electronic services. This solves the two-systems problem and frees money from the bricks-and-mortar government for digital technology.

Second, there is a political imperative for officials to use a service orientation so as to build a constituency for change. Most government innovations -- technological or otherwise -- require an external constituency. Someone from outside the public sector must be interested in and supportive for there to be a significant expenditure of government resources. This support could come from private groups, business associations or organized citizenry. In the case of e-government, public officials have sought to build support in two ways. They have appealed to the business community by making available contracts for the development and operation of service applications. In addition, they have emphasized service delivery to the middle-class, educated and affluent members of society because these are the individuals most likely to use the Internet and thereby benefit from online service delivery. Few of the alternative e-government visions that are available, such as interactive democracy or participatory democracy, offer the external support that is present in the area of service delivery. With the exception of some advocacy organizations, there is not a well organized body of citizens pushing the public sector to embrace the Internet as a tool for direct democracy.

Finally, the emphasis on service delivery relates to broader visions about social change. Of all the future e-government scenarios, a service-delivery focus is the one that is least threatening to the status quo. Options such as interactive democracy, participatory democracy or direct democracy are possible ways to transform the political system and society as a whole. Grass-roots organizations would be empowered by these models of democracy. Those who lack political power or financial resources could use technology to contest government policy.

Those visions of e-government clearly challenge major societal interests, however, so they have not been emphasized nearly as much by public officials as options based on electronic service delivery. Rather than pursue a vision that is threatening to the social and political status quo, e-government officials have preferred a technocratic vision emphasizing service to the business community and middle-class Internet users. These are the people who vote and contribute campaign monies, so it is a way to build longer-term political support for technology initiatives.

Online Enthusiasm
One of the most popular e-government services is tax filing. Citizens who are comfortable with the Internet like online tax service because it is convenient, speedy and reliable. Unlike the postal system, which occasionally loses parcels or has lengthy delivery delays, electronic transmission of tax materials is efficient and effective. In addition, for those awaiting tax refunds due to overpayments, both state and national governments advertise that people who file electronically will receive refunds in less than two weeks, which is twice as quick as those who send in paper copies. Electronic filing furthermore provides new tools for those who have a physical disability. On the IRS site, for example, the disabled can access "talking tax forms" developed by the agency that work with speech-generation software to file taxes online.

In general, the public is very enthusiastic about online tax filing. Federal electronic taxpayers receive an IRS acknowledgement that their forms have been tabulated and that their math adds up correctly. This increases confidence on the part of taxpayers that financial information has been filed correctly. If a proposal from President George W. Bush is adopted, the federal government would give electronic filers an extra 10 days beyond the current deadline to submit national returns. Since the federal government has set a goal of having 80 percent of taxpayers filing tax returns online by 2007, this proposal for extra time is designed to provide an additional incentive for electronic filing.

Government officials like online filing because it reduces errors when public-sector employees enter information from paper returns. It also cuts the flow of paper into filing centers. With millions of individuals and companies currently filing tax returns, the cost of storing and processing paper forms is very high. The government must maintain a very expensive staff and infrastructure to collect taxes in the United States. Since public officials would like to reduce the costs associated with tax collection, they have turned to online filing as a way to achieve this goal.

Furthermore, public officials like online filing because it generates revenue for other activities. Unlike alternative services that offer vital functions but do not generate much money, tax filing is the primary mechanism by which the government collects revenues for a wide range of services. In this situation, it is not surprising that public officials have made online tax filing one of their highest e-government priorities.

Eighty Percent Solution
In the United States, around 31 percent (40 million) of the 130 million individuals who report federal income tax returns filed electronically in 2001. Of these, around 32 million were delivered by tax-return professionals and eight million were computed by taxpayers themselves. This total is up from the 11.8 million who did so in 1995. In 2002, the number of online filers jumped to 52 million (41 percent), while in 2003, 60 million (or 46 percent) filed electronically.

The rate of increase from year to year has been slower than anticipated, however. Between 2000 and 2001, there was an increase of 13.7 percent, which was about half the level anticipated by the IRS and significantly below the percentage of preceding years. Between 2002 and 2003, the number filing electronically increased by 15.4 percent. This led IRS officials to question whether they will meet the national goal of 80 percent electronically filing by 2007.

In 2000, the Treasury Department created an online, e-payment system for transmitting tax payments to the federal government. Called EFTPS [Electronic Federal Tax Payment System]-Online, this electronic funds-transfer system enrolled more than 20,000 taxpayers and collected more than $2.8 billion in tax revenues in its first year of operation. Over the following year, the number of users rose to more than 832,000 and the revenues to $21 billion. The Treasury Department spent $9.5 million developing and rolling out this system.

As a sign of interest in online tax filing, the IRS reports there has been an upswing in visits to its agency Web site. From February to May 2001, for example, there were more than 13 million unique visitors to the Internal Revenue Service Web site. This represented a 57 percent increase of the 8.3 million unique visitors the preceding spring.

In general, citizen satisfaction levels with online filing have been quite high. Seventy-five percent of those filing their returns online indicated they were "very satisfied." Expanding the number of online filers beyond those who already do so is complicated, however, by lack of knowledge about how to file electronically. IRS research suggests taxpayers have problems with using its "self-selected PIN program" to file returns online. In around 2 million cases, confidential information taxpayers submitted to verify their identity did not match what the agency already had on file about the person. This inconsistency prevented taxpayers from submitting the return. Further, the absence of training programs made it difficult for the IRS to educate paper-filers about the advantages of online tax filing and showed how organizational factors often slow the spread of new technology in the public sector.

Processing costs to the federal government for electronic filing remain slightly below that of paper returns. Whereas it cost $4.28 to process a mailed-in paper copy, electronically filed returns cost $4.14 to process. By 2007, the IRS projects that the latter figure will drop to around $2 per return as more and more people avail themselves to electronic filing. If this happens, it will produce a major cost savings for the federal government, and free money for other budget priorities.

Free and Direct
The percentage of national tax filers is comparable to that at the state level, according to data provided by the IRS through its FSEF [federal/state electronic filing] program. As shown in [the E-Filing in 2002 sidebar] nearly 46 percent of tax filers in South Carolina file electronically, while at the low end, 22.6 percent of New York residents file their returns electronically. The average rate across all states was 32.2 percent in 2002, making the state figure a little less than the percentage for the federal government.

The roughly similar nature of the state and federal figures suggests that the fact that states allow for direct and free filing online while the federal government does not, has little effect on citizen usage levels. Interest group conflict over the development of federal online tax filing has altered the way the latter has developed, but has not constrained the ability of federal decision-makers to offer choices through commercial tax preparers that encourage citizens to file electronically. Vociferous group lobbying has shaped the way in which online tax filing has unfolded, but not citizen usage levels.

As Time Goes By
If one examines tax filing over time, there has been a major increase in the percentage of people in various states who file tax returns electronically. I collected detailed information from a number of different states around the country, and the data show a major increase in the rate of online tax filing. Every state has shown increases in online tax filing between 1998 and 2001. In most states, these numbers have doubled, and in some places even tripled.

By 2001, anywhere from one-quarter to one-third of citizens in most of these states were filing tax returns online through various formats (whether E-File, NetFile or TeleFile). For example, in Illinois the figure doubled from 11 percent to 22 percent, while in Missouri, it rose from 11 percent to 32 percent.

Clearly there have been significant improvements over a relatively short period of time in the percentage of the population relying on online tax services. As more and more people become familiar and comfortable with online tax filing, there should continue to be progress in this area. Since a number of states around the country have created ambitious benchmarks for electronic service delivery (80 percent usage over the next few years), they are providing specific incentives for citizens to rely upon online service features. These range from training and public education about online tax filing to offers of speedier returns and greater accuracy in the processing of tax returns.

Expensive Process
One factor that has constrained the development of online tax filing is the cost of implementing and maintaining this service. It is not enough to look just at citizen demand for online tax filing and usage of certain service options, but also at how much it costs the public sector to put together this kind of capability. There is no doubt that financial resources are a major factor in facilitating the spread of online tax filing, or that limited resources in some jurisdictions have prevented those areas from developing electronic tax filing options.

This demonstrates the role of budget scarcity in limiting the diffusion of technological innovation across the various levels of the American government. States that are poor have been slow to develop online tax filing; they have not managed to assemble a political coalition that can secure the financial resources necessary for this electronic service. Electronic tax filing is an expensive undertaking. To see how much it costs and the degree to which state governments have relied on in-house versus private contractors, I collected budget information from each state about online tax filing. In a lot of states, it has been difficult to develop precise cost estimates of online filing because electronic filing is not a single budget item. From interviews with agency officials, even they are not entirely clear on how many staff work on this kind of service delivery and what percentage of staff time is devoted to electronic as opposed to more traditional types of public access. Based on personal and telephone interviews with those who compiled detailed cost information, however, we were able to develop estimates on how much it costs to build the infrastructure for this kind of public service.

Most states have relied on outside contractors for the development of their online tax filing. Nine of the 16 states (56 percent) that provided detailed information on this subject outsourced the contract to private vendors, three (19 percent) performed the duties in-house, and four (25 percent) used a combination of outsourcing and in-house work (sometimes after hiring an outside vendor, being dissatisfied with the work product and shifting to an in-house work force). The commercial companies involved in developing these systems include GovConnect of Cincinnati; National Information Consortium (NIC) of Overland Park, Kansas; General Electric Information Systems; and a variety of local businesses.

Virginia had the most expensive electronic tax service of all the states. Its program cost $10.6 million over a five-year period running from 1998 to 2003. Massachusetts also ran one of the more expensive online tax filing systems in the country. Between 1995 and 2001, the state spent more than $4.5 million on its E-File program. Louisiana had an expensive program that cost around $1.8 million to operate.

In looking at cost figures for online processing, development costs in other states varied from a low of $20,000 in New Mexico and $25,000 in Iowa for Web-based systems to $200,000 in South Carolina and $350,000 in Maryland. Annual maintenance and operating costs once a system was put in place ranged from $5,000 in Wisconsin to $520,000 in South Carolina.

There is substantial variation across states in how sophisticated their electronic filing options are, how complex their tax code is, and what kind of software and hardware they employ to support online tax filing. The direct cost comparisons do not always mean one state is spending money more efficiently than others. Sometimes the differences shown are due to qualitative variations across the states.

In order to more fairly draw comparisons, some states calculate cost figures on a per-electronic-return basis. This means that they total the costs of running online tax filing, and then divide those figures by the number of citizens making use of the service. This allows the government agency to gauge the specific cost of each service provided and see how it might be able to achieve economies of scale as more and more people take advantage of the service. Since the expectation is better service delivery at lower cost, the hope is that as more citizens file electronically, there will be a drop in the per-return cost of tax filing.

In general, cost estimates from the various states ranged from 10 cents a return for electronic filing in Indiana to $50 a return in Iowa. Obviously the figures vary depending on how big a user base a state has to spread out the costs of the application, plus the expense of the contract to service electronic filing. States that have made greater progress in encouraging citizens to rely on electronic services reap greater dividends in terms of per-unit cost savings.

There are clear savings between electronic and paper tax filing. For example, Colorado reports that costs for processing electronic returns were only half as expensive as the price of paper returns. Whereas it took 42 cents to process an electronic tax submission, it cost 96 cents for each paper return that was processed. This cost differential mainly is due to the greater number of person-hours required to process paper tax returns.

Part of the efficiency gained through online filing is that the government does not need staff to enter information electronically from paper copies. The material arrives at the agency in electronic form, which saves considerable effort on the part of the revenue department. This is one of the ways the public sector economizes on electronic services, and a clear reason why government has an economic incentive to move to online services and encourage its citizenry to take advantage of available options.

Nearly every state surveyed reported reasonable satisfaction in terms of paying for the costs of implementing online tax filing. Based on our interviews, officials felt their particular payment system (either outsourcing or in-house development) had performed well, that they had a viable system, and that online filing was achieving cost savings for the particular agency.

Once a system is put in place, most states appear able to operate online tax filing with a few staff members (two to six IT specialists generally earning between $30,000 and $40,000). This is a relatively inexpensive system to operate given the large numbers of citizens who can be served and the convenience that is provided. Even these systems, however, require maintenance and periodic updates as the tax code changes over the course of time.

For states relying on the IRS to forward state tax payments and forms, costs are even cheaper. The expense to the state of maintaining this system is minimal since the federal government bears the bulk of the processing expenses. The IRS provides the staff and labor required to check returns and tabulate results, which means the cost to the state is relatively modest.

Based on these cost figures, it appears that the expense of online tax filing is reasonably low and there are clear economies of scale that can be achieved. Once such systems are put in place and 10 percent to 15 percent of the general public files returns electronically, the potential for cost savings and administrative efficiencies rises dramatically. In short, online tax filing is a powerful example of successful technological change that is pleasing to government officials and the general public that uses the service. Despite these advantages, however, it is not transforming the public sector because officials have succeeded in convincing only about one-third of current taxpayers to make use of this online service. Until larger numbers of citizens take advantage of Internet services, e-government's transformational potential will be limited.

Extensive Success
In terms of public satisfaction with online tax filing systems, most states reported extensive success in implementing the electronic service. Based on comments received from the public and reactions from officials who run the tax programs in various states, the technology appeared to function effectively, and taxpayers are happy with the results. Other than routine, scheduled maintenance, the online tax filing system does not go down and is available 24 hours a day, seven days a week, as advertised to the general public. States report having an infrastructure whose capability exceeds the number of people wanting to file tax returns online, at least when based on current usage levels.

Even during peak time, the first two weeks of April before taxes are due on the 15th, there have been few citizen complaints regarding the accessibility of online tax filing sites. There was more of a problem reported with TeleFile than NetFile. For the state of Illinois, for example, only 64 percent (147,081) of the total calls (229,722) to access TeleFile were successful. Few complaints, however, were recorded about NetFile, and most citizens said they found the system easy to use.

In Maryland, based on state memos, the General Electric network that supports online filing is "configured to achieve an internal target network availability of 99.8 percent with an internal goal of 99.95." Pennsylvania reported some problems in terms of service interruptions. A database problem caused multiple service slowdowns, although service never was completely lost. This led to some citizen complaints at times when the service was unavailable to those wanting to file taxes.

Virginia collects data on citizen satisfaction with online tax filing through its Web site. Overall, 97.9 percent of NetFile survey respondents said they found the service easy to use. Ninety-nine percent said they would use it in the future.

Adoption Struggle
Government officials have made good progress on developing online tax filing, but usage levels reveal that two-thirds of Americans remain outside the realm of this online service. Usage follows a model of incremental change rather than large-scale transformation. Satisfaction among customers is high, but growth rates have been more modest than projected by state and national tax agencies. There are a variety of organizational, political and financial reasons why citizen usage is not higher.

The biggest challenge facing the public sector has been putting systems in place that take full advantage of the power of the available technology. At the national level, an agreement between the Treasury Department and a consortium of commercial tax providers aims to boost online tax filing without the federal government developing its own infrastructure. Through links from the IRS Web site, as well as, private companies will provide free, online tax filing for up to 60 percent of American taxpayers -- around 78 million people altogether. Rather than having to bear the cost of creating its own online tax system, the federal government will rely on private tax preparers to transmit returns to the IRS.

Current usage of Free File remains limited, however, and there are few signs usage will increase much in the future. For example, a 2004 survey of Internet users who have not visited the Free File site found that 9 percent said they were very likely to visit the site the following year, 23 percent were somewhat likely, 19 percent were somewhat unlikely and 49 percent were very unlikely to visit the site. The conflict between federal government administrators who wanted to develop online tax filing and commercial providers who did not want the IRS developing this capacity is a clear example of political factors limiting the diffusion of technology. Without intense lobbying by private interest groups, the IRS was poised to move in the same direction that many state governments have gone: developing its own infrastructure for direct citizen filing of tax returns. It was only when these groups objected that the IRS stopped its development and signed an agreement allowing taxpayers to file returns through commercial preparers.

At the state level, many agencies have been hamstrung by a lack of online mechanisms for credit card payments, debit card withdrawals or electronic fund transfers. Illinois, for example, has implemented credit card payments, and in the first year, there were more than 4,000 credit card transactions. The state, however, would like to add a direct debit card program in the future. Missouri would like to implement an electronic funds withdrawal system for taxpayers. This would allow the state to directly withdraw funds from the taxpayer's checking account in order to pay tax liabilities.

Nearly every state reported plans for future enhancements to their online tax filing systems. While a number of states have Web-based systems for online income tax filing, most would like to put online comparable systems for paying corporate, sales and specialty tax obligations. Most focused on individual income tax systems first because of the large number of such payers and the costs of processing paper returns.

Another thing states would like to do is be more proactive about public education activities. Rather than waiting for citizens to arrive at their Web sites and use online services, some states would like to go out and educate citizens about the availability and usefulness of the service. This would promote online filing as an alternative to paper filing and help citizens learn to become more comfortable with electronic options for state service delivery.

In order to chart their own progress, a number of states have established benchmarks for the percentage of citizenry using online tax filing. Iowa, for example, has established a goal of having 80 percent of income tax filers using the online service by 2007 (the same as the federal government).

Through these and other types of public outreach efforts, governments hope to make citizens more at ease with online tax filing. Having created the technology that enables people to file electronically, the challenge now is getting more and more people to use this service. Even in states that have developed sophisticated applications, usage levels remain around one-third of taxpayers. Of states surveyed in 2001, Iowa had the highest participation at 33 percent, with others falling below that level. At the national level in 2001, 31 percent reportedly made use of online tax filing.

This means that most Americans still fall outside the realm of online tax filing. Both state and federal governments have optimistic plans to boost participation by 2007, but it is unclear whether these targets will be met. Part of the challenge with any new technology is making people comfortable with the invention; the United States has a "digital divide," meaning many Americans do not have computers and do not use the Internet. Public opinion surveys suggest that nearly one-third of Americans make no use of the Internet.

If online tax filing levels continue to lag state and federal projections, it will limit the cost savings that are generated via this particular electronic service. Large efficiencies occur only when substantial numbers of taxpayers make use of the electronic service. Governments have tried different types of incentives for online filing, but it may take direct financial incentives to boost electronic filing significantly. Revenue collection agencies could offer small cash rebates such as $50 for first-time, online tax filers. This would give people a material incentive beyond faster refunds and time extensions to encourage them to switch to online filing.

Some citizens have held back from accessing electronic services for fear over whether government agencies do an adequate job protecting the privacy and security of online transactions. The number of "hacker" attacks into government Web sites concerns Internet users. People must feel comfortable that filing taxes electronically and completing other kinds of online services will not compromise their personal information. Unless government Web sites reassure visitors (something that is becoming more common but still remains a major challenge), it will be hard to spread e-government usage beyond the educated and affluent who already rely on them.

Until usage levels rise substantially, it will be a major challenge for government officials to use technology to spearhead a transformation in public-sector service delivery. Citizens must actually make use of online services to achieve the economies of scale that will lower the per-unit cost of providing these kinds of services. Barring increases in public usage, service delivery will remain the purview of the elite and more well-to-do, and governments will not realize the cost savings hoped for from online service delivery. In this regard, there is a direct connection between lowering the digital divide in citizen usage patterns and budget savings. The Internet will not transform the fabric of the public sector until more users access electronic services.

West, Darrell; Digital Government: Technology and Public Sector Performance.
Darrell M. West Contributing Writer