Perhaps It’s Time For A Different Tax System
Its April, spring is finally in the air, and millions of Americans are busy assembling documents and receipts in an effort to meet the April 15 deadline for filing their income tax returns. It is estimated that taxpayers spend 7.6 billion hours and $140 billion a year to comply with the 73,954 pages in the federal tax code. Surely there must be a better way.
Not everyone is in this quandary. Some are not required to file tax returns because their income is below the threshold for filing. And some simply throw up their hands and turn to a tax preparation service.
According to the IRS, 56 percent of the 146 million personal tax returns filed in 2012 were submitted by such a service.
Besides the cost and inconvenience of filing an income tax return, I have a fundamental problem with the notion that we should report to the government all the money we earned during the year and how we spent it.
When evaluating a tax system, one should consider both the cost imposed on taxpayers and the revenue it generates for government. For example, a tax system that costs $10 to operate for every dollar it generates would not be considered efficient because it has a “deadweight loss” of 90 percent.
With taxes, there are three main costs: collecting the tax, complying with the tax and avoiding the tax.
The cost of collecting the income tax is basically the cost of operating the Internal Revenue Service. The IRS is under the Dept. of the Treasury and responsible for collecting excise taxes, employer taxes such as Social Security and Medicare, as well as the corporate and personal income tax. In 2014, the IRS had 91,555 employees, a budget of $12.8 billion and collected $2.5 trillion in revenue — approximately half of it coming from the personal income tax. So, if you eliminated the personal income tax, you could not abolish the IRS, but you could probably cut its size in half, if not more.
The cost of complying with income tax includes the cost of filling out tax forms and researching the tax code to identify the exemptions to which the tax payer may be entitled. In the last 50 years, the complexity of the tax code has grown exponentially. Individual taxpayers spend $31.5 billion a year for tax preparation services and tax software. The Taxpayer Advocacy Service of the IRS estimates that individuals spent 3.16 billion hours filling out tax forms which, if the labor is valued at $20 per hour, amounts to $63.2 billion.
Comprehensive audits add another $5 billion, bringing the total compliance cost to nearly $100 billion.
But the biggest cost, and one that is widely misunderstood, is tax avoidance. This is the cost of taking advantage of all those tax loopholes buried in the tax code. For example, municipal bonds are tax-free, but such bonds pay a lower interest rate than regular bonds. So if a person in the 40-percent tax bracket were to invest $1,000,000 in a 3-percent corporate bond, they would earn $30,000 a year, but pay a $12,000 income tax, for a net gain of $18,000 a year.
If they purchase a tax-free municipal bond that pays 2 percent, they will make $20,000 a year.
But is this really “tax free”? This investor is paying no income tax, but they are accepting $10,000 less interest to avoid $12,000 in taxes.
The real winner is the municipality that gets to pay lower interest on the bonds it sells to finance public projects.
The tax code is filled with loopholes — such as the solar tax credit that gives a dollar-for-dollar reduction in income tax for a person or company investing in solar equipment. The cost of this mal-investment is not only what the taxpayer gives up to qualify for the loophole, but the billions of dollars industries spend each year to influence politicians to obtain the loophole. In the end, investors gain little. And when you factor in the cost of lobbying, these industries may gain little as well. The clear winners are the politicians, which is why our tax code keeps growing more and more complex.
Alternative tax systems are the flat income tax, which would eliminate all tax loopholes, or a national sales tax. Various versions of a flat income tax are used in countries around the world because of its simplicity and low collection cost. But taxpayers are still required to report their income to the government.
A national sales tax is a tax on consumption rather than income. So instead of having to monitor 150 million individuals for compliance, the government only has to monitor retail businesses, and this is already done by 48 states in the United States.
One advantage of a consumption tax is that it would capture much of the unreported income from criminal activity, such as drug dealing and prostitution, as well as the earnings of undocumented workers when they spend their money.
Plus a consumption tax does not tax savings, which we want to encourage because it fosters investment.
If the personal income tax were replaced by a national sales tax while the corporate income tax is left in place, it would require a tax rate around 25 percent to replace the revenue generated by the personal income tax. But this would be a hard sell, because when it comes to taxes, most people like to be deceived: it’s like closing your eyes when they stick in the needle to draw blood. That is why some people let the government keep their money for a year interest-free while they pay 15 percent on their credit card balances, then celebrate when their tax refund check arrives in the mail.
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