Wednesday, January 2, 2013

The Cost of Tax Code Complexity

              The total expense of complying with tax obligations includes both the taxes paid and the cost of compliance.  For this reason, there is always a gap between the total burden placed on taxpayers and the amount the government collects.  As the tax code becomes increasing complex and time consuming, the gap between burden on taxpayers and collections can become significant.  In order to pay taxes, individuals and businesses must first spend time collecting records, organizing files, reviewing the tax rules and, in many cases, consulting with experts just to determine their tax liability.  All these costs rise with the complexity of the code.

              In a 2011 paper, Arthur Laffer (yes, the Laffer curve Laffer) attempted to estimate the direct costs of tax compliance.  (These are called direct costs because they exclude the indirect costs associated with tax related changes in behavior).  Here are the results.

Direct outlays, such as tax preparers or purchasing tax software - $31.5 billion (2010 data).

IRS administrative costs - $12.1 billion (2010 data).

Cost of 6.1 billion hours that individuals and business spend complying with the tax code - $377.9 billion (2008 data).

Cost of dealing with comprehensive audits - $9.3 billion (2008 data).

The total comes to $431 billion which represents more than 30 percent of the total income taxes collected in 2008.

              You might hope that in light of this cost of complexity, tax reform would be a top priority and there has been a great deal of talk about reform.  But when all is said and done, much more has been said than done.  The comprehensive Simpson-Bowles report appears to have been ignored since the day it landed on the President’s desk.  Meanwhile the complexity of the tax code has continued to grow.  The IRS Taxpayer Advocate’s 2010 report to Congress estimated that the 2010 tax code contained 3.8 million words, up over 2.5 times the mere 1.4 million words in the 2001 code.

              Finally, I spoke of the $431 billion as an estimate of the direct costs of complying with the tax code, but it is more appropriate to say attempting to comply with the tax code.  Given its complexity, even professionals are often highly uncertain whether a particular return complies with the code.  The Laffer paper points to a study by Money Magazine which asked 45 different professionals to prepare a return for the same hypothetical family.  The result was 45 different tax liabilities with the highest almost 3 times that of the lowest.

              The root of the complexity is not difficult to discern.  The desire to alter people’s behavior and advance social agendas, as well as collect revenue, pervades every nook and cranny of the tax code.  The result is an ever-growing array of special cases, that may have seemed like a good idea at the time, but which, taken in aggregate, have produced an indecipherable hodge-podge so complex that the only alternative is to rip it up and start afresh.

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