As Americans fill out their tax returns this April, they will enjoy the benefits of President Bush's tax cuts of recent years. But they will not enjoy the increasingly complicated tax rules they have to sort through. Tax rates are down, but tax complexity is way up.
Last November, a presidential tax commission sounded the alarm regarding the need for a major tax overhaul. Unfortunately, the president has not moved ahead with the commission's proposals, and most leaders on Capitol Hill are all talk but no action on reform.
Here are some reasons why we need action on tax reform soon:
- The number of pages of federal tax rules and regulations increased from 40,500 in 1995 to 66,498 in 2006;
- The number of pages in the IRS guide for Form 1040 increased from 84 in 1995 to 142 in 2005;
- The number of different IRS tax forms increased from 475 in 2000 to 582 in 2006;
- The cost of compliance for federal taxpayers - filling out tax returns and related chores - increased from $112 billion in 1995 to $265 billion in 2005;
- H&R Block's revenues from tax preparation soared from $740 million in 1996 to $2.2 billion in 2005;
- The complex alternative minimum tax hits 4 million taxpayers today, but will hit 30 million by 2010 if not repealed.
Recent tax bills have made some pro-efficiency reforms, but they have also added many pro-complexity breaks to the tax code. The number of special tax breaks for education increased from 7 in 1995 to 16 today. The number of breaks for the energy industry jumped from 11 to 26 during the same period. Politicians are increasingly using the tax code for social engineering.
Tax complexity imposes at least four costs on society. First, it creates a large and growing "tax industry" that draws some of the nation's brightest minds into unproductive activities such as designing corporate tax shelters.
Second, tax complexity impedes efficient decision making. For businesses, complex rules for depreciation, capital gains, and other items interfere with decisions such as capital investment and mergers.
For individuals, tax complexity confuses important life choices such as saving for retirement and making the career jump to self-employment. A recent survey by tax publisher CCH found that two-thirds of taxpayers could not correctly answer basic questions about the tax rules on home sales, retirement savings, and other items.
Third, complexity promotes an invasion of privacy by the government. The IRS needs to hunt for volumes of data to enforce the rules on all of the code's special breaks, such as those for education and housing.
Fourth, complex tax rules exacerbate noncompliance with the law. A recent government report found that the gap between federal taxes owed and taxes paid is about $345 billion annually. The aggressive tax avoidance we saw with Enron and other firms is not surprising given that the corporate tax combines intense complexity with a very high tax rate.
The good news is that reducing tax avoidance, simplifying the tax code, and boosting economic growth go hand in hand. For example, the current tax code has different rules for different types of businesses and investments. Tax lobbyists are expert at combining these disparate rules in unexpected ways to avoid taxes.
Such tax rule arbitrage would be ended under a Steve Forbes-style flat tax, which would treat all businesses in the same neutral manner. Also, the low rate under the flat tax would discourage loophole lobbying. The result would be that resources flowed to their highest-value uses, not politically favored ones, thus boosting U.S. productivity and output.
These advantages of tax reform have inspired a flat tax revolution in Central and Eastern Europe. Nine countries including Russia have enacted income taxes with low, flat rates and few special breaks. Our turn at tax reform should be next - Congress should end the micromanaging of society through the tax code and adopt a flat tax system that treats Americans with fairness and equality.