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.

Comments

[Grumpy Old Man]

The politics of income tax reform are intractable. You aren't easily going to get rid of the mortgage interest deduction, for example, and because so many expectations were based on it, I'm not certain we should.

I haven't read the calculations lately, but my recollection is that a value added tax, basically a sales tax, that exempts food and clothing would have about the same progressivity as the income tax. In those countries that rely primarily on a VAT, are the costs of collection less than our income tax system?

There are too many bells that can't be unrung--federal entitlements, "helping" bureaucracies with entrenched unions and lobbies, tax exemptions and credits favoring K Street clients, defense industries based on defending against yesterday's threats instead of todays--that I'm not sanguine at all about changing the tax system for the better.

We're headed for hell in a handbasket. The only satisfaction is that Canada and Europe are already in warmer territory thatn we.

[anonymous]

The day upon which personal tax returns are due should be changed from April 15th of each year to the Tuesday following the first Monday of November.

[Arun Khanna]

I agree. We should deduct deductions from the tax code.

[Michael]

I am somewhat skeptical of Prof Becker and the tax foundations estimates. It only takes me a couple of hours to prepare my taxes, and I use the long form with itemized deductions. Admitedly I earn nearly all of my income through normal wages (as opposed ot haivng my own business) which makes the whole process much simpler. However, I woudl question how much incremental work keeping tax books is. For example Prof Becker suggests that he and his wife spent 25 hours preparing documents to give to the accountant. However, it is not clear whether this time was in addition to personnal accounting that is necessary to make sure one is living within one's budget, making proper investments etc. In addition, I know that by setting one's personal accounting system up properly to begin with it is easy to generate a report of deductible expenses at the end of the year.

Even if Prof Becker has properly counted his pure tax preparation time (and has efficiently set up his peronal accounting system) I would suspect his time costs are in the tiny minority. The simple reason is that his financial situation is (I would suspect) relatively complicated. Presumably he earns income from a number of sources (teaching investments, speaking, writing etc) and with this has a nubmer of deductions. For tihs reason, I would suspect the amount of time he spends is well above average.

[Wes]

I agree that income tax for wage based income isn't that hard but taxes can get very complicated once investments are added in. If you believe the Republicans that people should provide for their own retirement then everyone needs a lot of investments.Let's consider some numbers. These days a couple needs about $50,000 per year to live comfortably not counting extra expenses like house and car payments. That means that a couple that retires at 65 and expects to live to 85 needs to have a million dollars in investments at age 65 in addition to having already completed payments on their house and cars.To save up a million dollars by age 65 a couple would have to be putting $30,000 per year into a retirement account starting at age 35 (in addition to paying off the house and putting the kids through college). That means that even by age 40 a couple should have $150,000 in investments. If the couple's investments are properly diversified that is going to involve at least 10 separate investments all of which are likely to accrue dividends and interest and capital gains and losses. This will be further complicated by tax breaks that are given to retirement accounts.Now, in the past, some people could rely on working for a single company their entire lives that would provide a sufficient retirement pension. In this case, the tax calculation burden was largely transferred to the company. In the modern economy where workers change jobs every few years, the burden of retirement planning falls on the individual and that can involve very substantial amounts of time for calculating taxes properly.

[paco]

Dear Prof. Becker, I agree with your analysis about the high compliance costs under the current system of taxation and the need for simplication. Indeed, I would go as far as to argue that the compliance costs under the current system are so large that there is an "optimal" amount of tax evasion; that is, that in some cases full compliance with the current system discourages productive activity, so that in these cases, evasion would be preferable from a "wealth maximization" persperctive. Of course, even if my hunch is correct, it would be a thorny empirical question to determine how much tax evasion is "optimal", but my larger point is that the more complex the system is, the more optimal evasion would be.

[Richard Mason]

I would separate the complexity of tax calculation into three kinds:

1) Complexity of a purely mathematical kind: the number of figures which have to be considered and all the additions, subtractions, multiplications, and divisions which have to be performed on them. In the modern world, this kind of complexity should no longer be of any significance since it can all be done by computer.

2) Recordkeeping: the burden of monitoring economic activity and recording transactions in a form that tax software can work with. Since almost everything can now be paid for electronically, it is also within our power to make this very easy if we choose.

3) Legal judgment: the need to know which provisions of the tax code can be or should be applied, and how transactions can be or should be characterized (e.g., whether an expense is deductible or not). This will be harder to computerize than the first two elements. Nevertheless I foresee that future taxpayers will be able to do this quite easily with the aid of sophisticated software.

There are some short-term obstacles. Some people still do not have computers, or credit cards. People may prefer recordkeeping to be difficult: for example, online businesses and their customers have an incentive to plead difficulty in calculating state use tax, and thereby avoid paying it, although recording and collecting the tax would in fact be very easy. But in the big picture, it seems to me that escalating complexity of the tax code will not be able to keep up with Moore's Law, and paying one's taxes is going to get easier and easier.

I predict, for example, that tax preparation will not be a growing profession in coming years, although like secretaries and travel agents, tax professionals will not become wholly extinct.

[Friedrich Tagle]

Mr. Becker, I want to sincerely congratulate you for such a fantastic contribution (together with Mr Posner) And if your time and dispositions allows it i`d like you to tell me your opinion on Raymond Aron, specially about the book "The imperial republic". Thank you very much.
F. T.

[Peter Pearson]

The General Accountancy Office (www.gao.gov) issued a report (11 April 2003, "Record Increase in Agencies' Burden Estimates) estimating a total US government paperwork burden of 8.2 billion hours, with the IRS accounting for 6.7 billion hours. Given that the average US work year is about 1800 hours, 6.7 billion hours per year amounts to 3.7 million full-time workers.

[Prole]

I'm sure that Becker and Posner have complicated taxes, but most Americans do not. My household income is 90th percentile and it only takes me a few hours to do the federal and state income tax forms. It would take even less time if my wife didn't have freelance income. The belly-aching about the complexity of taxes comes mostly from the affluent or from people who find it hard to add, subtract, and multiply whole numbers. They should use a calculator.

Instead of reducing the complexity of the tax code, which is a utopian project in a large and complicated democratic society, we could try to increase the financial and mathematical literacy of ordinary Americans. Many who go to H&R Block should be able to do their taxes on their own and save the fee. Investment in these basic skills would have benefits beyond tax preparation.

So let's require anyone who graduates from high school to be able to calculate the 1040 form for someone with a W-2, a modest amount of interest income, a mortgage, and charitable contributions. There is plenty of slack in the high school curriculum to teach such a valuable life skill.

[W]

Come on people. I did my taxes in 4 hours (including state taxes), and I got a nice refund. It isn't that hard. If it is so hard, you all must be much richer than me, and, you now, have retarded dependents, run charities, own farms, and make a habit of short-selling whaleskin futures. And I did it without a computer, thank God. We shouldn't force people to use computers if they don't want to. It is unnatural and oppressive.

[Haris]

I don't think "people should be able to do their own taxes, and quickly" is any argument in the discussion about the complexity of the tax code.

For one, society would be better off if people didn't have to spend their valuable time adding and subtracting and could use that time productively, or for leisure.
Second, record-keeping creates a real and significant time-cost that is just not noticeable because it is spread out throughout the year; thus, Prof. Becker's estimate of 25 hours is probably just barely above average when these hours are included.
Third, forcing or even encouraging people to simplify their sources of income to avoid compliance costs is inefficient, because when compliance costs wipe out the gains of an activity, that activity will not be undertaken, to the detriment of the economy.

So, arguing the numbers in this case won't contribute to the discussion about the overly complicated tax code, which is a real problem. Whatever the number is, whether $265 million or $26.5 million, the question is whether that number is too high [inefficient] and what it should be.

[Andy]

what's so bad about forcing people to spend a few hours each year to determining their tax liabilities? i agree that the code is too complex, but the time spent preparing taxes isn't all for naught-- it's good that people have to sit down and realize that providing this country's massive entitlement programs requires contribution, and it's good that people are forced every year to sit down and look how much they are contributing.

[ben]

W,

A reminder, because it appears you missed the point of this week's post, which is that the economy-wide cost of doing taxes is a significant and probably excessive fraction of the tax take.

What is the relevance of your own personal experience - are you saying everyone who takes longer is doing so unnecessarily?

[Gary Wolfram]

The primary problem in moving to a tax that is very simple is putting together the transition. The standard flat tax proposal has a tax base very similar to a consumption-based value added tax. As you point out, this will create winners and losers. It seems to me that providing a transition that would phase out exemptions and deductions, grandfather in certain items, etc,. while potentially creating a more compicated code in the short run, might allow a simple tax to emerge in the long run.

[lannychiu]

Very interseting arguments.

One additional cost to tax-payers that is not accounted for in any of the above estimates is the opportunity cost of provide funds to the government interest free.

If the population of the US were to, on average, overpay taxes then we would also have to add the cost of missed investment to the estimates above.

Don't know off the top of my head if the US population tends on average to over/under pay their taxes.

Also, there has not been much discussion of the potentially economically inefficient behaviors people engage in to take advantage of the tax system. For example, over-investment in real estate, or holding on to stocks too long in order to qualify for better tax treatment.

[BobK]

"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."

Not a good approach at all--except possibly for those taxpayers who (1) are not self-employed, (2) have no investment expense, (3) have not sustained casualty losses, (4) are not incurring vast medical expenses to keep them among the ranks of taxpayers, (5) and so on. A postcard-size tax form is a silly objective to have.

Income taxation is complex because the *definition* of periodic income is inherently complex. A true consumption tax is no simpler. (How do you tax consumer durables without distoring own vs. rent incentives?)

If you favor simplicity over fairness, you increase a compliance cost of another kind: non-compliance.

[JohnN]

While all the simplification ideas are great (whether flat or progressive) I don't see how any reform can be credible. If the change is only temporary (say for 15-20 years) before Congress starts making additional impositions will the transition costs (likely to be large) have been worthwhile?

Unlike the volunteer army, the advantages of tax simplification may be negated if those changes can be undermined by a variety of retro-taxes and exemptions in the future.

[Joe Merchant]

Wonderful sentiment - seasonally timed, and as you point out yourself: politically impossible. So, where to start? (You say you want a revolution.... well you know....)

I say we need to reform the creation of laws - and somehow take that activity out of the hands of the (self-interested) lawyers. Most educated citizens today are as competant (sp?) as lawyers of the 1700s, why not erase the bar? Perhaps with more complication in the tax codes making it economically unattractive to provide legal counsel in all but the most basic of cases - bring lawyers fees down to where they can make no more than the clients they represent.

With strong financial disincentive toward the legal profession, there should be an eventual erasure of needless complication, obfuscation, and other machinations which keep the lawyers in business today. There's no reason why government can't be transparent to all, with easy access to all laws, records, decisions, etc. from the home library (internet connection.) I'm sure we could retrain a small percentage of the lawyers out there to serve in the information technology field, enough to keep everyone's computers running.

Tax law is just one small example of the waste of effort society endures for the sake of making a minority a little bit wealthier, at a greater cost to the majority.

[W]

To all those who responded with arguments specifically attuned to my "non"-argument,

1. Anyone who has trouble doing their taxes deserves it, because they have so much money and engage in so many complex transactions that hundreds upon hundreds provisions of the tax code apply to them that their corporation's accountant should be doing the taxes;
2. For the average literate citizen who keeps his W-2 and any envelopes marked "Important Tax Information" handy, doing taxes should take no more than 5-10 hours, without a calculator. if it takes any longer than that, your W-2 and any such envelopes aren't kept handy, or you are illiterate.
3. Given that filing taxes is so easy and simple to do for the average literate citizen, forcing everyone to purchase a computer, or spending tax dollars to do so, is a waste. It also calls into question the motives of people who want the tax code changed. Any change will shift the burden off them, for whom doing taxes is difficult, to me, for whom doing taxes presently is easy. Why, exactly, should I subsidize your laziness? I shouldn't. Whining about doing your taxes is what isn't an argument, you lazy cretin.
4. Yes, I am talking to you.

[W]

For those of you who didn't get it the first two times: it's not your tax code that is too complex, it's you that is too lazy.

And I will add that the tax code is quite efficient. All sorts of goodies are in there, that save all sorts of people cash. Not you, perhaps. But someone. And that someone was given cash by their representative in Washington. Every provision of the tax code is proof of a political deal. Politicians exist to allocate resources, and the tax code is the Rosetta Stone of it. The tax code is quite efficient at what it exists to do, which is distribute goodies to the people who bothered to vote. I voted, so I love the tax code.

Apparently, ben, you were too busy reading becker-posner to vote.

[mvpy]

Prof Becker,
But isnt the time people spend doing taxes in some sense optimal in that if taxes were straightforward people would become less bothered by them. To put in differently, the time lost makes the burden of paying tax more salient engendering opposition to taxation. I think Milton Friedman made this argument, Im not sure. Basically, if the government could easily tax us painlessly, the upshot would be larger government and, ultimately, less efficiency.

[ben]

W - the first time I have seen pork barrel equated with efficiency. I'm with Collestro: you have no idea what you're talking about.

[PoliticalCritic]

Yes, the tax code should be simplified. In some states, it's actually very simple. For example, Pennsylvania's tax forms are quite easy. They tax the hell out of you, but doing them is not that painful. The federal government could easily follow this state or another state. They would save a fortune and save the public a lot of grief.

[Michael]

As I noted above compliance costs ofr most individuals are trivial (unless you have difficulties with arithmetic). One of the areas that introduces huge complexity, however, involves tax depreciation for business. This basically reduces the taxes of businesses that have made a lot of recent investment. Given that economists normally dislike taxation of investment income (since it is thought to distort investments) this is a good thing. Of course it would be even better (in this view) to reduce the rate of taxation on businesses; however, I would suggest that this would be politically impossible. The majority would have a serious problem with the idea that corporations are paying lower taxes than some poor shlom working at McDonalds. Therefore if we are in a world of second best where the current corporate rates cannot be changed, the question becomes whether the benefits from accelerated depreciation outweigh the compliance costs. I woudl strongly suspect they do since businesses could always choose to forgo accelerated depreciation, yet almost no businesses make this choice.