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.

Comments

[Arun Khanna]

U.S. government should ask a group of tax software firms to propose a simplified 100% e-filing and e-payment tax structure?

[W]

Not everyone owns a computer.

[Arun Khanna]

W said: Not everyone owns a computer.
With the savings in cost and time, everyone could afford a PC or local government could provide access to one, helping make U.S. achieve 100% computer literacy rate in a few years.

[DanT]

I say that tax simplification is a bad idea. The US Tax code is a large and complex social engineering experiment, and by many measures it works very well.

It promotes home ownership, because this tends to promote better citizenship. It reduces the cost of having children, because this tends to ensure more future citizens. It promotes personal charitable contributions, because this tends to reduce government spending. It promotes personal savings, because this tends to provide capitol to enhance the economy. In its most unsung benefit, it helps poor people so fewer feel they must resort to crime to survive.

Tax simplification would reduce or eliminate some or all of these benefits. That is a bad idea just to simplify the tax code.

[Arun Khanna]

Dan T said: I say that tax simplification is a bad idea. The US Tax code is a large and complex social engineering experiment, and by many measures it works very well. It promotes home ownership, because this tends to promote better citizenship. It reduces the cost of having children, because this tends to ensure more future citizens. It promotes personal charitable contributions, because this tends to reduce government spending. It promotes personal savings, because this tends to provide capitol to enhance the economy. In its most unsung benefit, it helps poor people so fewer feel they must resort to crime to survive. Tax simplification would reduce or eliminate some or all of these benefits. That is a bad idea just to simplify the tax code.

You are combining social welfare programs with the tax code. Simplifying the tax code will allow collecting taxes efficiently. Focus of social welfare programs will still be on implementation of such programs efficiently.

[Wes]

It promotes home ownership, because this tends to promote better citizenship.While there may be correlation between home ownership and good citizenship it is not clear that there is causation. Furthermore, it is not clear that those few people who choose to own a home because of tax regulations actually become better citizens as a result of being compelled to make that choice.It reduces the cost of having children, because this tends to ensure more future citizens.Any argument for a higher birth rate is also an argument for a higher immigration rate. If the USA wants more citizens it can get all the citizens it wants by opening up it borders with other countries.It promotes personal charitable contributions, because this tends to reduce government spending.Right. The war in Iraq was supported primarily by charitable contributions. My experience has been that most "charitable" contributions are actually to things like political advocacy that don't offset government spending.It promotes personal savings, because this tends to provide capitol to enhance the economy.It also discourages personal savings by taxing the savings and imposing complex accounting rules. There are a number of investments that I was tempted to make that I decided not to make because I didn't want the hassle of calculating the taxes I would owe. In fact, one of the main reasons I haven't opened up a specific retirement account is that it would make my taxes too complicated.In its most unsung benefit, it helps poor people so fewer feel they must resort to crime to survive.This, I sort of agree with. Pure capitalism results in a distribution of wealth where a few people are very rich and everyone else is very poor. Such a wealth distribution is very inefficient and basically destroys an economy. One of the key purposes of taxes is to prevent the economy from progressing to this extreme distribution.Having said that, tax complexity really has nothing to do with this. It is entirely possible for a very simple tax system to redistribute the wealth efficiently. The one thing a complex tax system does is confuse people but it is not clear that this makes the wealth redistribution any easier.

[Barton Thomas]

To paraphrase someone famous, complexity has a thousand fathers while simplicity is an orphan.

The best window for real tax reform was when President Bush took office at a time of large budget surpluses. Concurrently, the Joint Committee on Taxation prepared a detailed report on recommended measures to simplify the Code. The measures would have cost significant amounts of revenue to implement -- the largest cost being the elimination of the AMT. Unfortunately (in my own view), the Bush Administration chose a tax reform package that ignored most of the Joint Committee's recommendations and that actually made the Code several times more complex due to the sunset provisions. (As a footnote, these sunset provisions allowed the reform package to be exempt from filibuster and pass the Senate with a mere majority.)

Unless we can somehow restrain Federal spending, the opportunity for passage of those recommendations would appear to be lost.

[N.E.Hatfield]

Wasn't it B. Franklin who said, "The only sure things in life are death and taxes." Or as some wag put it, "The end of all political activity is to get the money out of the public." As life and society has grown more complex, so has the tax codes. If we wish to simplfy the tax code and hence make it more efficient, perhaps we need to make "life" more simple. Anyone willing to go back to the caves and savannah?

[Eric Rasmusen]

I wonder how much tax compliance cost is created by taxing capital income, especially capital gains. Labor income is much simpler, for most people (the self-employed being exceptions). If capital income were untaxed, that would also eliminate the need to tax trusts, another saving, and to keep track of what state-bond interest is exempt from federal taxes.

The other big item to look at in reducing compliance costs is record-keeping for expenses. If it were costless to keep records (and to verify them), then all income-generating expenses should be deductible. Since it is not, maybe even major expenses such as home offices and the use of vehicles should not be deductible-- as well as the more dubious hotel, food, and entertainment expenses.

[Chris]

Eric Rasmusen suggests exempting taxes on capital because it may be costly to tax. Isn't it simpler to exempt labor? After all, most people have no or trivial capital gains; by exempting labor from tax we can create a tax system which only taxes those well positioned to cope with the unavoidable costs.

I was a bit surprised by Posner's glib defense of the "compelling economic justifications" for many complexities in the tax code. Much of the complexity, from my seat, seems to derive from classic lobbying by small minorities for their advantage to the detriment of the majority. Surely an overwhelming simplification would have the advantage of levelling many of these advantages (which are unlikely to be economically efficient)?

[Zoey]

Why don't we just get rid of taxes and money and give everyone a gun and fifteen bullets.

[N.E.Hatfield]

There was once a scheme to get the Government: Fed, State, County, and Local to go over to using a "zero based budgeting scheme" in order to get the annual budgeting increases under control. That fell by the wayside. Then there was the scheme to create a progressive tax scale as opposed to the current regressive scheme now in use; by eliminating all loopholes and deductions and establishing a graduated tax rate based on income for all individuals (corporate and private). That also went up in smoke.

I guess it just goes to prove that no one wants to give up their perq's. and deductions. Like the old song goes, "Keep your hands off my stack!" "It's mine, mine, mine!" Ah, is greed really all that good?

[Tim Hollingsworth]

Sometimes it may be best to forget what I have seen in my 30+ years of dealing with federal taxation.
We actually got painfully close to "paperless" returns for the vast majority of taxpayers(90%or so). We could still get there. Raise the standard deduction so that it takes a big mortgage to justify itemization and scrape all the nutty credits (including Earned Income.) Most people don't have dividend income or capital gains. (They realy don't.) Do this and we are back to a 1040A on a old fashion IBM card. (Believe me, I have filed a tax return on an IBM card.

[W]

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.

The reason the tax code hasn't taken any of the forms suggested here is that people don't want it; what people want is what is in the tax code. People complain about agricultural subsidies all the time, but they are there for a reason: and there are people in Iowa who love the IRS.

[wsm]

Tax preparation fees are subject to the limitation on miscellaneous itemized deductions and thus are not deductible for the overwhelming majority of individual taxpayers. So this "reform" has been implemented.

I'm pretty skeptical that simplification will produce much in savings. The bulk of our tax preparation time goes into determining investment income, e.g., tracking basis, not computing deductions. (Maybe charitable deductions take a little time, but anyone who wants to can eliminate that problem by giving their entire charitable donations for the year in one lump sum to their church or the United Way or whatever.)

[Wilson Funkhouser]

Deductions were originally rationalized as necessary to tax individuals only on income that was truly disposible or a source of discretionary expenditures. Charitable giving was regarded a duty, and a reduction in such income.

Policy-based deductions that reduce the government's tax receipts can be seen as government expenditures to promote a policy.

To truly measure the costs of our tax system, wouldn't one need to measure the inefficiencies of such "tax reduction expenditures" as the mortgage interest and charitable deductions? Tax preparation costs are only one component of the inefficiency.

This isn't an original idea; Walter Blum discussed it at length in his income tax classes and had considerable data on this subject. Are scholars still trying to calculate these inefficiencies?

[spencer]

wes -- a retirement account is too complicated for you to bother??? It is one entry and one simple substraction. Get real.

But I know no one on principle that opposes tax simplification for everyone. But everyone is also fearful of losing their pet deduction.

We have met the enemy, and it is ourselves.

[Scott Stuart]

Posner talks about simplifying the tax code to reduce distortions on the market. What about using the tax code to correct other distortions? I think the biggest and most obvious one is to tax activities that create negative externalities such as the generation of pollution.

[Wes]

wes -- a retirement account is too complicated for you to bother??? It is one entry and one simple substraction. Get realOK. Let's look at a very simple example. Let's say that at some point in the future I need to take out a loan for a house or a car or my kids college tuition or medical expenses or something. Loans are expensive and any money tied up in a retirement account is money I will have to borrow at substantial cost to myself or incure complicated tax penalties.If, as you assert, retirement accounts are trivially simple, then give me the explicit mathematical formula for the net fincial impact of a retirement account (taking into account tax benefits from the retirement account and interest paid on the loan). Include all relevent variables such as my expected salary, expected interest rates, expected inflation rates, performance of the stock market, foreign exchange rates and the prices of houses, cars, college tuition, and medical services over the course of the retirement account (that is, over my lifetime).Furthermore, for those variables that are beyond my control, such as interests rates and even to some extent my employment prospects, provide an explicit formula predicting what these will be over the course of my lifetime. Note that for any of this to be meaningful you must be able to predict all the relevant variables with a high degree of certainty.

[Richard Mason]

Wes: Let's say that at some point in the future I need to take out a loan for a house or a car or my kids college tuition or medical expenses or something.

There are different kinds of retirement accounts. However for a Roth IRA, note there is no early withdrawal penalty if you are withdrawing the money to pay for a first-time house purchase, or for your kids college tuition, or for medical expenses which are more than 7.5% of your income.

There is no "car purchase" exemption. However there is still no early withdrawal penalty as long as you are only taking out money you put in (as opposed to the tax-shielded earnings of that money). You could purchase a perfectly good car with a retracted IRA contribution.

Wes: Note that for any of this to be meaningful you must be able to predict all the relevant variables with a high degree of certainty.

No, you do not need a very good estimate of how likely various scenarios are to conclude that you are better off with a retirement account in almost every realistic scenario.

[Bernard Yomtov]

Wes,

The tax code does not at all complicate saving for retirement. What it does is offer a number of tax-advantaged options.

There is no requirement that you set one up. You are perfectly free to save for retirement in a regular investment account. You forgo the tax advantages but avoid the tax complications you seem to fear. You can withdarw money without penalty for any purpose at all, and face none of the problems you describe.

It is just wrong to say that the option of having a special retirement account complicates retirement savings.

Of course Richard Mason is correct that you are almost certain to be better off by using a tax-advantaged account, but nobody is making you.

[Wes]

There are different kinds of retirement accounts.That's what's nice about the tax code - it's so simple.However for a Roth IRA, note there is no early withdrawal penalty if you are withdrawing the money to pay...There is both an early withdrawal penalty to consider and also a possible tax on earnings....for a first-time house purchase,...But only up to a lifetime maximum of $10,000 and last I checked homes cost a lot more than $10,000. Not only that but there are addition restrictions. There are requirements that the IRA has been open 5 years and "first-time home" actually means "has not owned a home for two years" so anyone the moves frequently is out of luck. Furthermore, only qualified expenses can be counted so paying off a mortgage is also out....or for your kids college tuition,...This avoids the penalty but not the tax on earnings so this is at best neutral....or for medical expenses which are more than 7.5% of your income.Right. I (or perhaps some relative) get hit with a major illness and the first thing I want to do is wade through massive tax regulations to see which expenses (and which relatives) qualify and if I somehow mess it up and deduct an ineligible expense then I could be thrown in jail or, at the very least, subjected to even more bizarre and complicated tax regulations. Thank you IRS.No, you do not need a very good estimate of how likely various scenarios are to conclude that you are better off with a retirement account in almost every realistic scenario.OK. Let's do some numbers. Let's assume that I end up with a Roth IRA that has $20,000 of earnings that are not eligible for early withdrawal. Let's say that because of this I have to take out a $20,000 loan at 10% for 10 years instead of merely losing 5% interest per year by using my savings. This is a net loss of 5% per year.By keeping the money in the IRA, I avoid a one time tax of roughly 20% on the $20,000 so I save $4,000 but then I lose $1,000 per year for 10 years on the loan for a total of $10,000. In the end I have lost $6,000 by opening the Roth IRA.This is hardly an unrealistic scenario. Maybe I haven't lost my shirt in this example but it does show that it is far from certain that opening an IRA is a good idea. Furhtermore, once the time to ensure proper compliance with all the many applicable tax laws is factored in, opening an IRA starts looking even worse.

[Wes]

There is no requirement that you set one up. You are perfectly free to save for retirement in a regular investment account. You forgo the tax advantages but avoid the tax complications you seem to fear.Whether there is a net financial benefit once loans and investing constraints are factored in, I agree that people who open IRA's probably do usually pay less tax than people who don't open IRA's. This is, however, as much a penalty inflicted on the people who would rather have simpler taxes as it is a benefit doled out to people who would rather have more complicated taxes.Putting on my cynical hat, I suspect that the vast majority of people lack the skills and the time to accurately calculate the financial consequences to themselves of opening an IRA. It may be that, on average (whatever that means), there is a net financial benefit to opening an IRA. My suspicion, however, is that most people do so for emotional rather than rational reasons.The careers of both investment advisers and loan officers are advanced when people lock themselves into IRA's. As a result, a situation has arisen where people are ushered into luxurious offices that are designed to reflect affluence and security and they are then told that the affluent and secure choice is to open an IRA. Having rules to follow - from the authority of the federal government, no less - makes people feel secure. Blind obedience to authority is validating for many people. By following the rules, people affirm their place as an law obiding members of society.I was initially shocked when a substantial fraction of the posts this conservative leaning weblog were in favor of a complicated tax system. The more I think about it, the more it seems to reflect the conservative desire for obedience to authority.

[Bernard Yomtov]

I was initially shocked when a substantial fraction of the posts this conservative leaning weblog were in favor of a complicated tax system.

Well, I'm not a conservative, but I have a response to this anyway. I do not favor a complicated system, but I disagree with the people calling for drastic simplification for two reasons.

First, the current system really isn't that complicated. Despite all the complaints and whatnot, the fact is that filling out a tax return should be, for most taxpayers, a simple task. Those who are overwhelmed by the job of doing three or four pieces of simple arithmetic and then looking the result up in a table aren't going to be able to manage under a different system either.

Second, I don't really believe that a replacement system would be any simpler. Read Becker's post. The complexities are there because of the political process, not because some wizard figured out that they were components of the perfect system. The exact same thing will, I think, happen with any reform. There will always be choices to be made, arguments for this or that treatment, and lobbying and maneuvering. I simply do not think that new tax legislation will come out of Congress significantly simpler than what we have, or that it will stay that simple even if it starts that way.

[Tom Klein]

Many interesting comments. They will not be implemented, because they all belong to one of two categories. They represent either a real or perceived self(or group) interest, or they are an expression of an individual's or group's concept of "fairness". Since they are inherently divergent, not only that we cannot satisfy all, but as time goes on , they will become more numerous and divergent as the concept of both "self interest" and "fairness" will expand in both in number and scope. In my mind , the only solution to the problem is to stop looking at the Government - and taxation with its most visible manifestation - as some omnipotent parent that we can demand either dispensation from chores (taxes), or distribution of goodies in the name of "need" or " fairness". In my mind the only way to look at the Government as a giant service organization, which is entitled to receive compensation from the beneficiaries of the services it provides . For example it provides a free and democratic political system with an independent judiciary and national defence. This benefits everybody, so everybody should pay some taxes. It provides a very elaborate system of protection for private property, so owners of private property should pay for for this protection. The payment(or taxes if you like) - like an insurance premium - should be proportional to the value of the assets being protected. We have an elaborate system of consumer protection,- the FDA is probably the most expensive example - so a consumption tax is a legitimate charge for services provided. The hardest time I have is to come up with a similarly good justification for the income tax - other than it is easy to collect-.