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.

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