The Penalties of Our Tax Code
Friday, April 12, 2013
Our tax system’s unnecessary complexity creates unfairness and uncertainty. With a few reforms, it could be more growth-friendly, simple, and fair.
With April 15 quickly approaching, Americans are spending large chunks of time wading through paperwork, poring over forms and instructions, and entering information into tax preparation software – or they're paying to outsource the ordeal.
Complaints about tax complexity are common at this time of year. While some degree of tax complexity is inevitable in a large, diverse, and dynamic economy like ours, unnecessary complexity creates unfairness and uncertainty and hinders economic growth. Fortunately, a handful of reforms could create a tax system that is more growth-friendly, simple, and fair.
The Internal Revenue Service’s taxpayer advocate estimates that the total compliance cost of the federal individual and corporate income tax system was $168 billion in 2010 – or about 15 cents for every dollar of taxes collected. This cost includes not just money spent on accounting services and software, but also the value of taxpayers’ time spent keeping records and preparing returns. And that’s just federal taxes. Most taxpayers have to deal with tax complexity at the state and sometimes local level as well.
These compliance costs are a waste of resources. Paying taxes shuffles wealth around rather than creating new wealth. The hours spent preparing tax returns could be better spent working – or for that matter, just watching TV or sipping lemonade on the porch. The programmers who produce and update tax preparation software could instead produce iPhone apps that consumers enjoy or use to increase their own productivity.
High-income taxpayers’ compliance costs are a smaller share of their incomes than the costs faced by middle- and lower- income taxpayers.
In addition to wasting resources, tax provisions leave much room for disagreement on the nuances, subjecting taxpayers to a great deal of uncertainty. Tax complexity allows some taxpayers to exploit rules to their advantage, while others lacking the required expertise and resources are left paying more. The burden of complexity falls disproportionately on particular groups – such as the self-employed – who are not necessarily wealthy.
In fact, Joel Slemrod, an economist at the University of Michigan and an expert on taxes, argues that tax compliance costs are regressive. Although compliance costs increase with income, they do not increase proportionately. High-income taxpayers’ compliance costs are a smaller share of their incomes than those faced by middle- and lower- income taxpayers.
Fortunately, taxes don’t have to be this complicated. Of course, some complexity is inevitable if we want to properly consider people’s individual circumstances. But there’s plenty of unnecessary complexity in the tax code and many ways to reduce it.
My colleagues at the American Enterprise Institute, Kevin Hassett and Aparna Mathur, together with Lawrence Lindsey, have argued that the Earned Income Tax Credit, the Child Care Credit, the Child Tax Credit, and other tax breaks for low-income families create complexity through their varying eligibility requirements, phase-ins, and phase-outs and could be consolidated. Similarly, the various deductions and credits for higher education costs could be combined and simplified, as could the numerous tax-preferred savings accounts.
The total compliance cost of the federal individual and corporate income tax was $168 billion in 2010 – or about 15 cents for every dollar of taxes collected.
Other pro-growth reforms would also result in a simpler tax system. Our current tax code provides breaks for many politically favored pursuits like home ownership and certain kinds of energy. If some activities are favored by the tax code, people make decisions that they might not have made otherwise, because the true costs and benefits of their various choices are distorted. Ideally, people would make decisions based on actual costs and benefits. Eliminating or overhauling many of these tax breaks would make our society more prosperous. And, on net, this kind of reform is likely to reduce the complexity of the tax code.
In addition, as my AEI colleague Alan Viard points out in his recent book with Robert Carroll, taxing consumption rather than income is not only good for growth, it also simplifies the tax system. Under an income tax, people who spend money immediately rather than saving it bear a lower tax burden over their lifetimes. In contrast, under a consumption tax, spenders and savers are treated the same. Because saving and investment are not punished, economic growth increases over the long term. The simplification comes from the fact that a consumption tax eliminates the need to measure changes in wealth, which can often be tricky.
Given the federal government’s long-term fiscal imbalance, it’s likely that policymakers will consider significant changes to the tax code over the next several years. They should focus on reforms that can increase prosperity, improve fairness and transparency, and reduce complexity.
Sita Nataraj Slavov is a resident scholar at the American Enterprise Institute.
FURTHER READING: Slavov also writes “Let’s Raise Taxes on the Middle Class” and Slavov and Benjamin Ho discuss “The Shrinking Health Gap.” Alex Brill contributes “Understanding Tax Fairness (and Why the Buffett Rule Is a Distraction),” Kevin A. Hassett examines “The Progressive U.S. Tax Code,” and James Pethokoukis asks “What Has Obama Got Against Private Savings and Investment?”
Image by Dianna Ingram / Bergman Group