The Price Paid for a Complex Tax Code

Andrea Louise Campbell has penned an awesome article on the US tax system in Foreign Affairs.It is titled America the Undertaxed: U.S. Fiscal Policy in Perspective. She opens with this terse summary:

"Compared with other developed countries, the United States has very low taxes, little redistribution of income, and an extraordinarily complex tax code. These three aspects of American exceptionalism deserve more attention than they typically receive."

We have discussed Campbell’s comments on the issues of tax level and income redistribution in The United States: Undertaxed Nation. Here we will cover her points with respect to the characteristics of the US tax code.

The US taxpayer who would choose to tackle the task of filing personal income taxes on his/her own faces a formidable foe.

"To get a sense of the immense complexity of the U.S. system, consider that the Internal Revenue Code is almost 12 times as long as the New Testament. The 2012 instruction booklet for the 1040 individual tax form and the accompanying schedules is 188 pages long; the one for the "EZ" [easy] form is 43 pages."

Not surprisingly, a large and prosperous industry has grown up around the task of helping people make their way through this maze of forms and questions. Computer software can now be purchased to minimize the pain. Sadly, even the poorest tax return filer, one who has no tax to pay, but who would receive a significant payment from the Earned Income Tax Credit, feels the need to share some of that benefit with a professional tax preparer in order to insure that the forms are filled out properly and that they receive their money with no delay.

"A 2003 IRS [Internal Revenue Service] report estimated that individual taxpayers pay $18.8 billion, spending 25 hours and $149 per taxpayer, on compliance each year, mainly through payments made to accountants and agencies to help them sort out their taxes. Corporate taxes are even denser. According to the U.S. Treasury Department, large corporations spend over $40 billion annually on compliance."

That is a lot of money; and it involves a lot of people. Consequently, there exist lobbyists who actually argue against simplifying the tax code.

To avoid the appearance of creating programs that spend funds, Congress creates tax deductions, grants, refunds, and subsidies that distribute money in the hope of accomplishing something. Besides being dreadfully inefficient, they add complexity to the tax code because forms must be filled out to determine both eligibility and the amount of money involved.

"The tax expenditure system is one major reason for this intricacy. Each exclusion, deduction, and credit adds another layer of complexity to the code and increases the time needed to prepare one's taxes. Taxing families rather than individuals complicates the system even more, since this method makes it difficult to calculate the proper tax withholding for each partner. Another culprit is the Alternative Minimum Tax (AMT), which is meant to prevent high-income taxpayers from using exclusions and deductions to avoid paying the federal income tax. This system requires some taxpayers to calculate their tax liability twice, once under the regular income tax and then again under the AMT, and pay whichever is higher."

Not surprisingly, Campbell can point to countries that have better ways of doing things.

"Several dozen countries utilize a return-free system for most taxpayers. They can do this because they tax individuals rather than families and withhold taxes from both income in the form of wages and income in the form of interest. These two features allow countries to precisely calibrate withholdings to actual tax liabilities. It is also much easier to implement such a system when governments hand out tax breaks either as credits that are equal for all taxpayers or as deductions that are set at a flat rate. In the United Kingdom, for example, the equivalent of the U.S. home mortgage interest deduction is a flat 15 percent reduction on the interest paid on the mortgage applied directly by the bank."

Campbell provides the effort required to deal with allowances for children as an example of how matters could be handled more efficiently.

"Many advanced-country governments calculate and send allowances to families with children. In the United States, however, households with children must navigate and administer a complex system of tax breaks themselves, such the Child Tax Credit and the Earned Income Tax Credit. And if they file their returns incorrectly, the IRS may fine them. That is why even many low-income families rely on tax-preparation firms, which have lobbied against periodic attempts to simplify the tax-paying process, such as having the IRS mail out draft returns for households in straightforward situations."

Does that last quote imply that the US does not have an "advanced-country government?"

There is another cost—one that does not show up directly in terms of dollars and cents.

"....it [complexity] undermines public trust in the system, with taxpayers fearing that those with better knowledge of how to navigate the system of loopholes, particularly the rich, get away with not paying their fair share."

People often claim that we are accumulating so much debt that we run the risk of becoming Greece. Debt is not going to make us into another Greece. Our major problem involves the large number of people who have no trust in government. If that distrust ever bleeds over into tax compliance, then we have a big problem. Right now, most people pay their taxes. If distrust in the government, and its tax code, ever reaches the stage where people feel free to avoid paying their share of taxes, then we will have become Greece.