April 16, 2006
Tax Simplification and Complexity
Tax Complexity and the Cost of Compliance-BECKER
As my wife and I were recently preparing our income tax data to give to our accountant, I began my annual guess about the cost of complying in the U.S. with the Federal Tax code. But instead of just shaking my head over it, as I usually do, I made a few simple calculations that I will share with our readers. I will also offer some suggestions on how to cut down drastically compliance costs and reduce the negative effect of federal taxes on the efficiency of the economy.
We spent at least 25 hours in 2005 preparing and keeping track of our 2005 income, deductible expenses, and other data relevant for tax purposes. Our accountant spent another 6 or so hours, so together our tax filing used over 30 hours. Last year the IRS processed about 130 million tax returns. If the average filer along with any professional help together spent about 20 hours, 2.6 billion hours would have gone into complying with the 2005 tax code. This may seem huge, but the Tax Foundation put much more effort into their calculations, and finds that about 6 billion hours were spent in complying with the federal income tax code alone.
Businesses spend many more hours than most individuals do, while many filers who primarily have taxes withheld by their employers spent less time because they use the "short" tax form. Still, over half of all filers consulted accountants, lawyers, or other professionals for assistance in preparing their taxes. During the tax season, apparently over 1 million persons work professionally helping others prepare their tax returns.
If we value my 2.6 billion hours estimate conservatively at an average of about $40 per hour because higher income filers and tax preparers spend many more hours in tax preparation than lower income filers, the aggregate cost of complying would be over $100 billion. This is almost 10 per cent of the approximately $1.2 trillion that will be paid in 2005 in federal income taxes. The Tax Foundation concludes that total compliance costs for 2005 will amount to $265 billion, or over 20 per cent of federal income tax revenue.
Even with my lower estimate, compliance costs are big, despite the availability of computer software that greatly helps in tax preparation. The culprit is clearly the complicated tax code that has produced over 66,000 pages of federal tax rules. Of course, these complications are not there by accident, but are the result of pleadings and lobbying (see our discussion last week of lobbying) by special interests for favorable tax considerations. These include efforts by builders and home owners to get the government to allow deductions for interest paid on mortgages, by philanthropic organizations and universities to have charitable contributions deductible from reported income, by state and local governments to allow the deductibility of state and local income and property taxes, by industries lobbying to get accelerated depreciation on capital purchases, and special tax provisions for the oil and gas industry. They also include lobbying by financial institutions to get incomes accumulated in IRA's to be tax free, by employers and other groups that prefer the earned income tax credit over more generous welfare payments, and so on for the many pages in the tax code.
These numerous provisions not only enormously raise the direct cost of tax compliance, but cause many changes in behavior to take advantage of favorable treatments in the tax code. These alterations in behavior, like expenditures on compliance, usually make the economy less efficient, whether because many talented lawyers and accountants spend their time finding tax loopholes, or because too many and very large houses are built to take advantage of the favorable tax treatment of housing expenses, or because of many other changes in behavior.
Complications in the tax code are an excellent example of the conflict that sometimes arises between what is rational at the individual level, and what is rational to society as a whole. Each interest group lobbies to promote the interests of its members, although their interests advance usually at the expense of the interests of others. When many groups succeed in promoting their interests, losers vastly outweigh winners since each group gains from what they do, but loses from what is done to them by hundreds of other powerful interest groups.
There is no magic cure to this problem, at least none that I have encountered. Still, it is valuable to see clearly the problems and how they might be corrected because the future may provide opportunities for reform that are not presently available. A window of opportunity could arise to implement thoroughgoing changes that are not now politically feasible. One example of this kind of process is the voluntary army: a pipedream in the 1950's and 1960's became feasible in the 1970's because of the discontent over the draft during the Vietnam War.
The only way to radically reduce compliance costs is to engage in drastic surgery on the complexities of the tax code. The best approach would be to essentially eliminate all deductions, and have tax rates based just on total consumption, or as a second best alternative, just based on total income. Then compliance costs would be small because taxes owed could be calculated on a form the size of a postcard.
Such a radical simplification is often confused with a flat tax, which is a tax that is the same percent of income at all income levels. But eliminating all special deductions and benefits does not imply a flat tax, nor does a flat tax imply enormous tax simplification. In fact, most people who propose a flat tax really are proposing a progressive tax structure since they want incomes below a certain level to be free of all income taxes, and then a constant tax rate on each dollar of income about this minimum level. One could still have low compliance costs with a greater degree of progression in rates if tax rates started at zero and rose as incomes increased. Most degrees of tax progression are consistent with low compliance costs, although the more complicated the degree of tax progression, the greater the alterations in behavior that reduce an economy's efficiency.
To return to the cost of tax compliance, it is obviously excessive and socially wasteful. It is not easy to be optimistic about the prospects for tax simplification since the fundamental trend over time in the United States has been a steady increase in the complexity of the tax code. But at some future time, concern over the social waste in compliance costs that amounts to between 10 and 20 percent of total revenue produced by the income tax may galvanize American taxpayers into a revolt that, at least for a while, would result in drastic simplifications of the tax code.
Tax Simplification--Posner's Comment
An article by the economists Edward Lazear (now chairman of the Presiden's Council of Economic Advisers) and James Poterba published in The Economists' Voice last December estimates the annual costs of preparing federal tax returns at $100 billion and, like Becker, uses this high figure as the basis for arguing for simplification of the federal income tax. A difficult project that, as far as I know, has not yet been undertaken would be to estimate the actual savings from simplification. Unfortunately, they might turn out to be modest.
H&R Block obtains total revenues of almost $2 billion a year from preparing tax returns for almost 20 million taxpayers, most of rather modest means and, presumably, rather uncomplicated returns. The average expense of tax preparation to these taxpayers is thus $100. The total number of federal income tax returns filed this year will be almost 140 million. If one assumes that the bedrock expense of preparing each of these returns is $100, then a simplified income tax system would cost $14 billion. This would represent a considerable saving over the present system, but the $14 billion figure is undoubtedly a gross underestimate in two respects. First, it ignores the time cost to the taxpayer (emphasized by Becker) of obtaining, and forwarding to the tax preparer, the information needed to complete a tax return. Second, drastic simplification would impose significant social costs. There are compelling economic justifications for allowing some deductions or credits, examples being charitable contributions, expenses for the production of income, and foreign and other duplicative taxes. Computing these items often involves unavoidable complications, such as how to value charitable gifts that are made in kind rather than in cash and how to determine when business expenses are really expenses rather than disguised income. To the economically efficient deductions and credits must be added certain sacred-cow deductions and credits that aren't going away, of which the most attractive is the earned-income credit. Moreover, even if there were no deductions, there would be bound to be complications in computing tax due on nonsalary income. And some income that escapes taxation at present, such as the imputed rental income of owned housing, should be taxed in order to avoid distortions, and an attempt to do so would impose additional tax-preparation costs.
All this is not to suggest that tax simplification is not a good idea and would not produce genuine cost savings, though probably only in the 10 percent range. Two measures that would tend to produce savings without simplification would be, first, not allowing tax-preparation fees to be deducted from income tax and reducing marginal tax rates, since the higher those rates, the greater the benefit of efforts to find tax loopholes and hence the more cost that will be incurred in such efforts.
Because the potential benefits from tax simplification are likely to be modest, perhaps greater political effort should be devoted to trying to make the tax system more efficient in the sense of maximizing the ratio of tax revenue to the distorting effects of taxation on the allocation of resources. An ideal tax is a tax on a good or service or activity that is inelastic (Adam Smith's example was a tax on salt). Such a tax will not induce many people to substitute some other good or service or activity for the taxed one, and such substitution both is inefficient and reduces the revenue collected by the tax.