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.