On Dec. 23, the Treasury Department issued a new study of tax simplification. It discusses ways in which millions of taxpayers could be relieved of having to file any tax return at all. However, a new report by Congress’s Joint Committee on Taxation (JCT) explains why this probably won’t happen.
The problem of complexity has plagued the federal income tax from its beginning in 1913. As early as 1928, the JCT issued a report containing many familiar complaints. However, it concluded that there was a severe limit to tax simplification, because the complexity of modern business operations necessitated a high degree of complexity in the tax system.
Not only does tax complexity follow from business complexity, it causes it. As New York Times reporter David Cay Johnston details in his new book, Perfectly Legal, many businesses are now organized in extraordinarily complex ways for the sole purpose of minimizing their tax burden. But legislative and administrative efforts to plug “loopholes” only create more complexity, which tends to create new tax-saving opportunities for the clever to exploit.
For big companies, tax complexity is a necessary fact of life and they can afford to hire experts to figure it out. But for small businesses and individuals, complexity imposes a real cost. In 2002, the General Accounting Office found that small businesses overpaid their taxes by $18 billion over the previous two years because of errors on their tax returns. Another GAO report that year found that as many as 2.2 million taxpayers overpaid their taxes by not taking advantage of all the deductions they were legally entitled to.
A new JCT report shows just how hard it is to take advantage of all the tax provisions that might save on taxes. It lists all the so-called tax expenditures, including five pages of new ones enacted just last year. The really big ones, however, are not those that benefit big businesses, but the middle class. For example, more than 33 million taxpayers avail themselves of the mortgage interest deduction, saving them $59 billion in taxes. Thirty-eight million taxpayers claim deductions for charitable contributions, for a tax saving of $37 billion.
It is doubtful that many taxpayers claiming such deductions would give them up just to get a simpler tax system. As Brookings Institution economists Bill Gale and Leonard Burman have observed, “Most people don’t mind complexity that directly reduces their taxes.” Indeed, one of the most complex provisions of the tax code is the Earned Income Tax Credit, which often involves a tax rebate for people with no income tax liability. People don’t mind this complexity too much, however, because the payoff is so large.
According to the JCT, the effect of the EITC is to completely wipe out the aggregate tax liability of every American with an income below $30,000. This group actually got a “refund” of $16 billion more than their tax payments. As a consequence, 40 percent of all tax returns now report a zero or negative tax liability.
The Treasury study suggests that many of such people could be relieved from filing any return at all. Moving toward a system in which tax withholding exactly matches one’s tax liability could potentially eliminate filing for as many as 50 million people, about a third of all those currently filing returns. But this would require employers, financial institutions, and other income providers to do more work and also require them to know much more about the financial affairs of those receiving wages and other payments from them.
In the past, taxpayers have strongly resisted further intrusions into their financial privacy and any expansion of tax withholding. For example, a few years ago Congress enacted legislation requiring banks to withhold taxes on interest income in order to improve tax compliance. People raised such a stink about it that the legislation was quickly repealed. But this sort of thing would be necessary to make a return-free tax system work.
The most important conclusion of the Treasury study is one that has been echoed in all previous studies of tax simplification: The tax law itself is too complicated. Radical simplification of the law would have to precede any effort to greatly simplify tax paying for more than a small number of people. This doesn’t just mean rewriting the law to make it clearer, but fundamentally restructuring the tax law from top to bottom.
Former House Ways and Means Committee chairman Bill Archer (R., Tex.) now believes that income itself is the major barrier to simplification. It is just too hard to define. Therefore, we must move toward taxation of consumption if we are to make real progress toward simplification. People may have to pay more of their tax bill in the prices of the goods and services they buy if they want to rid themselves of filing tax returns.