Tax policy reform, part 2

There are good reasons to consider rethinking our tax laws and policy. Part 1 discusses some context and a major flaw, intentionally lax enforcement of tax law with loss of hundreds of billions in tax revenue each year. This post describes a couple more major flaws in U.S. tax law and policy.

The perception of unfairness

Perceived unfairness in the tax code fosters cynicism and non-compliance by average taxpayers. Actually, this isn't just a perception. It is reality. Workers who are classified as employees have essentially no opportunity to under report their income because it is subject to tax withholding. Those employees report about 99 percent of their earned income (U.S. Tax Advocate, 2010 annual report, page 7).

By contrast, compliance rates drop dramatically for workers not subject to tax withholding. Non-farm sole proprietors report only 43 percent of their business income and unincorporated farming businesses report only 28 percent (U.S. Tax Advocate, 2010 annual report, page 7). Tax noncompliance cheats honest taxpayers, who must pay more to make up the difference. According to the IRS’s most recent comprehensive estimate, the net tax gap stood at $290 billion in 2001 (IRS Updates Tax Gap Estimates, IR-2006-28, Feb. 14, 2006; U.S. Tax Advocate, 2010 annual report, page 7). This meant that each taxpayer in 2006 was paying a “surtax” of about $2,200 to subsidize noncompliance or tax evasion by others.

Is that fair or not? When average Americans see gross unfairness in this magnitude of tax cheating, is that cynicism or just seeing reality?

Wasteful compliance burden

The tax code is blindingly complex. Complying with tax law imposes a large but unnecessary burden on the economy. One estimate is that is requires about $125 billion annually for businesses and individuals to comply with tax law. Another estimate is about $163 billion, which is about 11% of receipts (U.S. Tax Advocate, 2010 annual report, page 4). The annual tax code compliance burden requires more 3 million full time workers or about 6.1 billion hours per year (U.S. Tax Advocate, 2010 annual report, page 3).

For the most part, that effort is a nonproductive burden our economy must carry while struggling to compete with low cost economic competitors, e.g., China, Indonesia and India. Obviously, the cost of compliance cannot be reduced to zero. But, it would be reasonable to expect a reduction of at least 50%-60% in compliance cost. That would yield a saving of about $60-$95 billion annually.

One has to ask, can we afford to continue this or not? Does our economy need help in the form of reducing unnecessary burdens like this? Or, do we just keep on with business as usual? One thing is certain, if this is left to the Democratic and/or Republican parties we will have business as usual.

Malignant incentives to cheat

The tax code is opaque and subject to manipulation by wealthy individuals and corporations (U.S. Tax Advocate, 2010 annual report, page 5). Those individuals and corporations take full advantage of their opportunities to avoid and evade taxes. Expoliting those advantages, of course, makes sense and would be expected. Current tax rates are such that the incentive to evade taxes is too powerful to resist for many individuals and entities.

That economic incentive coupled with the staggering complexity of the tax code leads to what one would expect - massive tax evasion. One recent study estimated tax evasion amounts to about $450-$500 billion with about $2 trillion in income going unreported. Other estimates are lower, e.g., the GAO estimates about $330 billion per year. Although the amount of evaded taxes is staggering, there is nothing remarkable about it. The situation simply reflects Adam Smith's invisible hand responding to economic opportunity in free markets. Our current tax code is too complicated and riddled with massive flaws to ignore. Tax law and policy provides the market and the opportunity to make very large amounts of money with little or no risk. That's hard for anyone to resist.

Assuming the estimates of tax evasion are accurate, it would be reasonable to expect hundreds of billions of increased revenues from a reformed tax code that (1) incentivizes compliance by reducing tax rates, (2) deincentivizes tax evasion by vigorous (real) enforcement of tax law in all economic sectors, (3) minimized opportunities for tax avoidance by simplifying tax law and (4) broadening the tax base to create a sense of common community and reduce public distrust of our current corrupt system.

Although that is easy to say, it will be difficult to implement. Neither of the two political parties want to make major changes. That is understandable because the system benefits them. Most of the people behind much of America's wealth feel the same way for the same reason. Again, no surprise. Things are the way they are for good reasons - there are powerful interests who want it this way. They will fight against meaningful change. Real reform will have to come from outside the two party system.