What the Ideal Tax Code Looks Like

Tuesday, December 15, 2015
Authors: 
Jason J. Fichtner

Tax reform is a hot topic in Washington, D.C. But luckily, policymakers need not fly blind when it comes to defining the principles key to a successful revenue system.

The most basic goal of tax policy is to raise enough revenue to meet the government's spending requirements in the way that has the least impact on the economy. Academic research suggests that, to meet this goal, a successful system should be simple, equitable, permanent, and predictable.

The U.S. tax code does not live up to these standards. In fact, while most developed countries have lowered their corporate tax rates and restructured their tax systems to make them simpler, the United States appears to be taking the opposite approach. The current tax code distorts market decisions and hampers job creation, reducing both economic growth and tax revenue.

The statutory corporate tax rate in the United States is the highest in the industrial world — a factor that encourages businesses to move to lower-tax countries, taking jobs, money, and tax dollars with them. The costs of tax compliance in the U.S., meanwhile, may be nearly a trillion dollars annually, including accounting costs, economic losses, and lobbying expenditures.

Contributing to these costs, dozens of tax provisions set to expire every year are repeatedly extended in a seemingly endless cycle. This process is evidence of the tax code's complex and temporary nature — two faults that increase both uncertainty and costs for American people and businesses.

Clearly, the nation's economic and fiscal situation has increased the motivation — and the urgency — to reform the federal tax system, along with the federal government's other unsustainable institutions and practices. But what would an ideal tax code look like?

One thing policymakers should not do is raise tax rates. There is much research showing the negative consequences of raising tax rates on economic growth. Research by Christina Romer, former chair of President Obama's Council of Economic Advisers, and David Romer, an economist at the University of California–Berkeley, suggests that "a tax increase of 1 percent of GDP reduces output over the next three years by nearly 3 percent."

With tax cuts in mind, some have claimed that the Tax Reform Act of 1986 is model legislation for future reform. But despite the law's perceived success, it failed to fix the revenue system's large institutional problems, and the key reforms it did include were clawed back almost immediately. As a result, the tax code looks even worse today than it did before the reform.

Keeping the tax code as simple and as transparent as possible will reduce the incentives to reverse future tax reforms. This can be done by taxing a broad base at a single low rate, and by removing distortionary tax benefits that treat similar activities unequally.

In the individual tax code, for example, policymakers should work to reform the mortgage-interest deduction and marriage penalty. Consumer advocates view the mortgage-interest deduction as a benefit for lower- and middle- income taxpayers, but most of the benefits from the deduction go to high earners, and it encourages unnecessary levels of debt and borrowing.

Similarly, the marriage penalty creates unequal taxation among couples whose only differing characteristic is their marital status. The structure of joint income-tax filing creates a significant tax disincentive to marriage and raises the cost of working outside the home for married women. The negative effects of the marriage penalty are greatest for low-income households.

To regain competitiveness, the United States should also reduce its corporate tax rate to 25 percent at most, the average rate of other Organisation for Economic Co-operation and Development (OECD) countries — a move that will benefit everyone in the economy. U.S. corporate taxes have been shown to fall primarily on labor. This means that the taxes paid by U.S. corporations are mostly passed on to employees through lower wages and benefits.

The tax code's complexity is also evident in the rules applied to corporate capital investments. A reform called "full expensing" — under which businesses may deduct all their capital expenses from their taxable income immediately, instead of gradually over the life of the asset — would be another move toward a better tax system.

History has shown that tax reforms seldom last when special interests have substantial incentives to lobby Congress for tax breaks. Making the tax code as simple and as transparent as possible will help to ensure that future tax reforms aren't quickly reversed.

The Hidden Cost of Federal Tax Policy

December 8, 2015

The most basic goal of tax policy is to raise enough revenue to meet the government’s spending requirements with the least impact on market behavior. But the United States’ tax code has long failed to meet this aim by severely distorting market decisions and the allocation of resources—hampering job creation and impeding both potential economic growth and potential tax revenue, while burdening Americans with up to $1 trillion in compliance costs. This book sets a general framework for evaluating the societal benefits of any tax provision and presents key problems that exist with the tax code today.

To increase employment and expand their economies, most developed countries are both reducing their corporate tax rates and restructuring their tax systems to make them simpler. The United States appears to be taking the opposite approach. While there appears to be widespread agreement on the need for tax reform, there is no consensus on specific elements of reform. This book shows that successful tax reform needs to be predictable, permanent, simple, efficient, and equitable. Reforms should include lower marginal tax rates, a broad base that eliminates loopholes, no double taxation, and reduces bad incentives. To move the debate forward, policymakers need to know the goals of successful tax reform and what steps to take to achieve those goals. This book provides that essential knowledge.

Table of Contents

Click each chapter title to download the PDF.

Introduction: What Are the Goals of Tax Policy?

Chapter 1: What Are the Hidden Costs of Tax Compliance?

Chapter 2: What Can Be Learned from the Tax Reform Act of 1986?

Chapter 3: Why Should Congress Restructure the Corporate Income Tax?

Chapter 4: Why Do Workers Bear a Significant Share of the Corporate Income Tax?

Chapter 5: How Does the Corporate Tax Code Distort Capital Investments?

Chapter 6: Why Should Congress Reform the Mortgage Interest Deduction?

Chapter 7: How Do People Respond to the Marriage Tax Penalty?

Conclusion: Key Principles for Successful, Sustainable Tax Reform

Why We Should Scrap Mortgage Interest Deductions

Thursday, July 31, 2014
Authors: 
Jason J. Fichtner

The mortgage interest tax deduction is often justified as promoting homeownership among the middle class and supporting industries that employ middle-class workers. The deduction also has broad public support: a recent survey found that six out of ten Americans oppose its elimination.

But such support is misplaced. Over 64% of the MID tax benefits go to tax filers earning more than $100,000, according to our new study released through the Mercatus Center at George Mason University. While the upper middle class does benefit from the deduction, the vast majority of the dollar benefits go to higher-income taxpayers. Little to no dollar benefits go to low-income households that purchase a home.

Our study examines the economic effects of the mortgage interest deduction in addition to assessing the tax break’s policy effectiveness. We argue that, considering the political hurdles that full repeal might create, policymakers should instead seek to replace the MID with a fixed $900 credit for all taxpayers with a mortgage.

The purported public policy role of housing-related tax deductions and credits is to increase homeownership. But as currently structured, the MID fails to significantly increase homeownership among its intended beneficiaries, and it encourages greater debt among homeowners. In short, the MID is generally giving a tax break to households that would likely purchase homes anyway and enabling high-income households to buy homes that are roughly 10–20% larger than those they would otherwise buy.

Of the 65.2% of tax filers claiming to make less than $50,000, a mere one in ten claims the mortgage interest deduction. One reason that low-income and many middle-income taxpayers are unlikely to use the MID is that the standard deduction is likely greater than any itemized expenses. Unless annual mortgage interest expenses, combined with any other expenses that are allowed as itemized tax deductions, are greater than the standard deduction, a taxpayer will not opt to itemize deductions. According to data from the Internal Revenue Service, it is only after reaching $100,000 in income that three-fourths of tax filers use the MID.

Other countries also demonstrate an inconclusive relationship between the MID and homeownership. In the case of the United Kingdom, which phased out the MID between 1975 and 2000, the homeownership rate rose from 53% in 1974 to 68% in 2001. While the increase in homeownership may or may not be a direct result of phasing out the MID in the UK, at a minimum, the phase out did not decrease homeownership.

Much of the justification for owner-occupied housing subsidies focuses on encouraging individuals who would not otherwise have sufficient savings to acquire home equity. Yet as Yale economist Robert Shiller points out, other foreign countries such as Switzerland have higher rates of household saving even without high homeownership rates.

The MID could likely be eliminated with minimal effects on low- and middle-income taxpayers. Only a full repeal of tax-favorable housing policies in exchange for lower marginal tax rates for all taxpayers will eliminate economic inefficiencies. Elimination of the MID in exchange for lower marginal rates and a higher standard deduction would represent a general improvement in the standard of living for almost all low- and middle-income taxpayers.

This hypothesis has already been proven by the The Tax Reform Act of 1986, which significantly reduced the value of the MID by reducing marginal tax rates and increasing the standard deduction. The lower tax rates significantly diminished the use of the MID by lower-income households, although the reduction in use was not quite as great for high-income households.

Eliminating the MID may slightly decrease the demand for housing among some low-income households that actually have sufficient mortgage interest to itemize. But this decrease seems relatively small, given that the MID is used so infrequently by low-income households. The bulk of the decrease in the demand for mortgage debt would come from households with large loans that exceed the loan limits of Fannie Mae and Freddie Mac.

A cleaner tax code would also move the housing industry away from its current tax-driven overvaluation. Revenue-neutral tax reform that eliminated the tax bias toward housing might encourage higher-income households to shift some housing investments to more socially productive investments, such as stocks or bonds.

If tax-favored housing must exist, it should, at a minimum, promote homeownership among low-income and middle-income households. A successful tax-favored housing policy would be designed to encourage households at the margin to purchase a home—that is, those homeowners who would like to own homes but would not do so without a federal subsidy. For example, offering a fixed, nonrefundable $900 credit to people who have a mortgage could increase homeownership among low- and middle-income households by as much as 5%, while only decreasing homeownership rates among high-income households by 1%.

By reforming the MID from a deduction to a credit, the purported policy goals of supporting homeownership would be more properly aligned with actual outcomes. A cleaner, simpler tax code brings more equality to investment opportunities and is a step toward greater tax fairness.

The mortgage interest tax deduction is often justified as promoting homeownership among the middle class and supporting industries that employ middle-class workers. The deduction also has broad public support: a recent survey found that six out of ten Americans oppose its elimination.

But such support is misplaced. Over 64% of the MID tax benefits go to tax filers earning more than $100,000, according to our new study released through the Mercatus Center at George Mason University. While the upper middle class does benefit from the deduction, the vast majority of the dollar benefits go to higher-income taxpayers. Little to no dollar benefits go to low-income households that purchase a home.

Our study examines the economic effects of the mortgage interest deduction in addition to assessing the tax break’s policy effectiveness. We argue that, considering the political hurdles that full repeal might create, policymakers should instead seek to replace the MID with a fixed $900 credit for all taxpayers with a mortgage.

The purported public policy role of housing-related tax deductions and credits is to increase homeownership. But as currently structured, the MID fails to significantly increase homeownership among its intended beneficiaries, and it encourages greater debt among homeowners. In short, the MID is generally giving a tax break to households that would likely purchase homes anyway and enabling high-income households to buy homes that are roughly 10–20% larger than those they would otherwise buy.

Of the 65.2% of tax filers claiming to make less than $50,000, a mere one in ten claims the mortgage interest deduction. One reason that low-income and many middle-income taxpayers are unlikely to use the MID is that the standard deduction is likely greater than any itemized expenses. Unless annual mortgage interest expenses, combined with any other expenses that are allowed as itemized tax deductions, are greater than the standard deduction, a taxpayer will not opt to itemize deductions. According to data from the Internal Revenue Service, it is only after reaching $100,000 in income that three-fourths of tax filers use the MID.

Other countries also demonstrate an inconclusive relationship between the MID and homeownership. In the case of the United Kingdom, which phased out the MID between 1975 and 2000, the homeownership rate rose from 53% in 1974 to 68% in 2001. While the increase in homeownership may or may not be a direct result of phasing out the MID in the UK, at a minimum, the phase out did not decrease homeownership.

Much of the justification for owner-occupied housing subsidies focuses on encouraging individuals who would not otherwise have sufficient savings to acquire home equity. Yet as Yale economist Robert Shiller points out, other foreign countries such as Switzerland have higher rates of household saving even without high homeownership rates.

The MID could likely be eliminated with minimal effects on low- and middle-income taxpayers. Only a full repeal of tax-favorable housing policies in exchange for lower marginal tax rates for all taxpayers will eliminate economic inefficiencies. Elimination of the MID in exchange for lower marginal rates and a higher standard deduction would represent a general improvement in the standard of living for almost all low- and middle-income taxpayers.

This hypothesis has already been proven by the Tax Reform Act of 1986, which significantly reduced the value of the MID by reducing marginal tax rates and increasing the standard deduction. The lower tax rates significantly diminished the use of the MID by lower-income households, although the reduction in use was not quite as great for high-income households.

Eliminating the MID may slightly decrease the demand for housing among some low-income households that actually have sufficient mortgage interest to itemize. But this decrease seems relatively small, given that the MID is used so infrequently by low-income households. The bulk of the decrease in the demand for mortgage debt would come from households with large loans that exceed the loan limits of Fannie Mae and Freddie Mac.

A cleaner tax code would also move the housing industry away from its current tax-driven overvaluation. Revenue-neutral tax reform that eliminated the tax bias toward housing might encourage higher-income households to shift some housing investments to more socially productive investments, such as stocks or bonds.

If tax-favored housing must exist, it should, at a minimum, promote homeownership among low-income and middle-income households. A successful tax-favored housing policy would be designed to encourage households at the margin to purchase a home—that is, those homeowners who would like to own homes but would not do so without a federal subsidy. For example, offering a fixed, nonrefundable $900 credit to people who have a mortgage could increase homeownership among low- and middle-income households by as much as 5%, while only decreasing homeownership rates among high-income households by 1%.

By reforming the MID from a deduction to a credit, the purported policy goals of supporting homeownership would be more properly aligned with actual outcomes. A cleaner, simpler tax code brings more equality to investment opportunities and is a step toward greater tax fairness.

Low-Income Taxpayers Benefit Least from Mortgage Deduction

July 7, 2014

One of the most commonly cited justifications for the mortgage interest deduction (MID) is the claim that the deduction promotes homeownership among the middle class and supports industries that employ middle-class workers.1 But with 65.2 percent of all tax filers claiming to make less than $50,000, only 9.8 percent of these returns used the mortgage interest deduction. By an economic valuation, the MID is a sizable tax subsidy—one of the largest tax deductions in the code (behind the exclusion of employer contributions for medical insurance premiums and the exclusion of all pension and retirement contributions), which decreased federal revenues by an estimated $69 billion in 2013. While the upper middle class does benefit from the deduction, the vast majority of the dollar benefits go to higher-income taxpayers while little to no dollar benefits go to low-income households that purchase homes. 

One reason that low-income and many middle-income taxpayers are unlikely to use the MID is that the standard deduction for an individual taxpayer in 2014 is $6,200 ($12,400 if married and filing a joint tax return). Unless annual mortgage interest expenses (combined with any other expenses that are allowed as itemized tax deductions) are greater than the standard deduction, a taxpayer will not opt to itemize deductions. Instead, the individual will take the simpler and more financially sound route of using the standard deduction.2 

The purported public policy role of housing-related tax deductions and credits is to increase homeownership. As currently structured, the MID fails to significantly increase homeownership among its intended beneficiaries, and it encourages greater debt among homeowners.3 In short, the MID is generally giving a tax break to households that would likely purchase homes anyway and enabling high-income households to buy homes that are roughly 10–20 percent larger than those they would buy otherwise.4

Economic inefficiencies will only be eliminated with a full repeal of tax-favorable housing policies in exchange for lower marginal rates, but if tax-favored housing must exist, it should at a minimum promote homeownership among low-income and middle-income households.

1 Rick Judson, “Keep Homeowners’ Tax Deduction: Opposing View,” USAToday, April 2, 2013, http://www.usatoday.com/story/opinion/2013/04/02/mortgage-tax-deduction-editorials-debates/2047927/.

2 The standard deduction serves two important roles: to simplify the tax code and to favor lower-income taxpayers by making the tax code more progressive. Part of the design of the standard deduction is rendering it unnecessary for some taxpayers to track their tax-related expenditures throughout the year, since that cumulative effort wouldn’t exceed the standard deduction. For millions of taxpayers, simply taking the standard deduction saves time and resources. However, the standard deduction is also designed to reduce the taxable income of low-income taxpayers, regardless of whether any tax-related expenditures have been incurred. (Along these lines, tax-related expenditures might be viewed as having gone to waste. In short, in a world where there must be tax-favored spending, it seems that increasing the number of low- and middle-income housing units would reap more social benefits than an equal amount of money in subsidies given to high-income earners.)

3 David C. Ling and Gary A. McGill, “Evidence on the Demand for Mortgage Debt by Owner-Occupants,” Journal of Urban Economics 44, no. 3 (1998): 391–414; James R. Follain and Lisa Sturman Melamed, “The False Messiah of Tax Policy: What Elimination of the Home Mortgage Interest Deduction Promises and a Careful Look at What It Delivers,” Journal of Housing Research 9, no. 2 (March 2000): 179–99.

4 John E. Anderson, Jeffrey Clemens, and Andrew Hanson, “Capping the Mortgage Interest Deduction,” National Tax Journal 60, no. 4 (December 2007): 769–85; Harvey S. Rosen, “Housing Decisions and the U.S. Income Tax: An Econometric Analysis,” Journal of Public Economics 11, no. 1 (February 1979): 1–23.

Reforming the Mortgage Interest Deduction

June 19, 2014

The mortgage interest deduction (MID)—the second largest tax break in the United States at $69 billion per year—has long been touted as a critical tool for promoting middle-class prosperity and homeownership. But Americans may be surprised to learn that the only taxpayers who receive a large benefit from this deduction are those in upper income brackets; most taxpayers don’t benefit at all from the deduction.

In a new study for the Mercatus Center at George Mason University, Jason Fichtner and Jacob Feldman review why the current MID has failed to accomplish its intended purpose of expanding homeownership for the middle class, and instead has encouraged higher levels of debt and borrowing by households that can already afford a home. The study examines various reform proposals, and concludes that—failing the ideal but politically difficult reform of repealing the tax break and lowering marginal rates—policymakers should replace the MID with a nonrefundable credit for homeownership to better align the tax break with purported policy goals.

To read the study in its entirety, please see “Reforming the Mortgage Interest Deduction.”

KEY POINTS

Who Benefits from the Current MID?

Supporters of the mortgage interest deduction often argue that it promotes middle-class homeownership. However, 64 percent of the benefits—as measured by effective tax reduction—go to households earning more than $100,000.

  • Very few lower-income households claim the MID. Of the 65 percent of taxpayers claiming income of $50,000 or less, fewer than 10 percent use the MID. Households earning $50,000 or less typically don’t pay enough in mortgage interest expenses (and other tax-deductible items) to itemize rather than using the standard deduction ($6,200 for an individual, $12,400 for married couples).
  • Because higher-income earners pay higher marginal tax rates, they benefit from claiming the MID. The average effective tax reduction for a filer earning between $100,000 and $200,000 is $1,420—nearly 10 times larger than the $150 saved by taxpayers earning between $30,000 and $50,000 who are able to use the deduction.
  • The MID generally encourages high-income earners who are already likely to buy homes to buy homes that are 10 to 20 percent larger than those they would have purchased without the MID.
  • The United States has a lower homeownership rate (65 percent) than a number of countries that do not have mortgage interest deductibility, including Italy (71 percent), Australia (70 percent), Canada (68 percent) and the United Kingdom (68 percent).


Economic Impact of the MID

The preferential tax treatment for housing under the MID encourages overinvestment in housing at the expense of more economically productive investments.

  • Because the MID increases the demand for housing, the deduction has increased home prices by between 10 and 15 percent. Also, a greater demand for housing increases the demand for debt. As a result, higher interest rates may offset between 9 and 17 percent of the MID’s benefit for taxpayers.
  • Taxpayers in the past have altered their investment portfolios in response to tax code changes. For example, when the Tax Reform Act of 1986 ended the deduction for consumer debt, higher-income earners increased their consumption of mortgage interest, which was still deductible, rather than investing those funds in non-tax-favored investments.
  • As with most tax deductions, it is a mistake to assume that eliminating the MID would allow the government to collect all the forgone revenue, as taxpayers would find other ways to minimize their tax burden. It is estimated that eliminating the MID could generate as little as 25 percent of the revenue currently forgone by the deduction.

Policy Options

Due to the regressive effects of the benefit distribution from the MID and the deduction’s failure to achieve stated policy goals, several reforms could make tax policy related to housing more effective at helping intended beneficiaries. But these proposals are unlikely to eliminate the negative economic impacts created by tax preferences for housing.

  • Refundable and nonrefundable tax credits. Research finds that a refundable credit equal to 21 percent of mortgage interest paid would raise total homeownership by 3 percentage points. This strategy represents a useful starting point for reform, but could be simpler and better targeted by setting the credit at a specific value.
  • Fixed credit for homeownership. Under this option, taxpayers would receive an annual credit for owning a home, regardless of whether they held a mortgage. Analysis of this option with a 1.03 percent credit on the purchase prices of homes costing up to $100,000 finds that it would lower taxes on the bottom four income quintiles. However, there is no estimate of how such a proposal would impact housing demand.
  • One-time homebuyer credit. Some have suggested replacing the MID with a one-time credit for first-time homebuyers. Supporters argue this would promote homeownership among lower-income households. Critics counter that it would not increase aggregate homeownership.

RECOMMENDATIONS

Ideally, policymakers would repeal the MID and lower marginal tax rates to eliminate the economic inefficiencies created by tax preferences for housing. The impact on lower-income households would be minimal, as only a small percentage file itemized tax returns. Revenue-neutral reform would prompt higher-income households to shift money toward more productive investments.

Considering the political hurdles that full repeal would create, policymakers could instead seek to replace the MID with a fixed $900 credit for all taxpayers with a mortgage. This revenue-neutral credit could be granted for a set number of years for owner-occupied homes and adjusted periodically for inflation. Such a credit could increase the homeownership rate, while also reducing tax code complexity and without encouraging greater debt-financing by home purchasers.

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Business As Usual

Monday, April 28, 2014
Authors: 
Jason J. Fichtner

The Senate will soon vote on the infamous $85 billion “tax extenders” bill (the EXPIRE Act), the 15th such renewal of a host of expiring “temporary” tax provisions. Tax economists generally agree that temporary tax policies are ineffective for economic growth, so why will these tax breaks likely be renewed yet again?

The regular renewal of tax breaks is a vehicle for politicians to acquire financial and political support from special interests in exchange for tax handouts. In the 1990s, federal tax policy was relatively stable, with relatively few expiring tax provisions. But today’s large number of temporary tax provisions signals to those who benefit from the provisions that Washington is open for business.

Mercatus Center research finds that a higher number of temporary tax breaks means more spending and investment in lobbying activities. Rather than emphasizing productive jobs, a growing supply of lobbying jobs emerges to protect various industries’ tax privileges. The Senate Finance Committee Chairman Ron Wyden, D-Oregon, has noted that the tax extenders’ “stop and go nature obviously contributes to the lack of certainty and predictability needs to create more family wage jobs.”

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The High Costs of a Terrible Tax Code

Tuesday, May 28, 2013
Authors: 
Jason J. Fichtner

Washington has long used the federal tax code to advance objectives ranging from increasing "fairness" to granting a competitive advantage to favored businesses or industries. But riddling the code with special provisions has a price beyond the revenue lost from the tax breaks themselves.

In a new Mercatus Center study, "The Hidden Costs of Tax Compliance," we document the costs and implications of the grossly complex U.S. tax system.

The Treasury forgoes approximately $450 billion per year in unreported taxes. Worse, Americans face up to nearly $1 trillion annually in hidden tax-compliance costs. And according to the IRS, taxpayers spent more than six billion hours in 2011 complying with the tax code – that's enough to create an annual workforce of 3.4 million people. If that workforce was a city, it would be the third largest city in the United States. If that workforce was a company, it would employ more individuals than Walmart, IBM, and McDonalds, combined.

The complexity of the tax code also creates an uneven playing field for taxpayers.

About one-third of U.S. taxpayers itemize deductions. This increases the costs of filing taxes and distorts the costs of goods and services ranging from homes to medical care. These deductions also benefit those at the higher end of the income spectrum, as less than 15 percent of households with earnings below the U.S. annual median income file an itemized tax return.

Also, specialized tax incentives favor larger, more established firms. Smaller businesses often are unable to take advantage of provisions such as tax deductions for interest payments and debt financing, and often lack the resources and scale to comply with a complicated depreciation schedule for capital investments.

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The Hidden Costs of Tax Compliance

May 20, 2013

Washington has long employed the tax code for purposes extending beyond collecting revenue to fund the federal government. Lawmakers use special provisions inserted in the code to advance objectives ranging from increasing “fairness” to granting competitive advantage to favored businesses or industries.

The price of riddling the tax code with special provisions is, however, far higher than the revenue lost from the tax breaks themselves. The true cost of tax compliance also exceeds the obvious time and money expended on tax preparation.

A new study published by the Mercatus Center at George Mason University surveys the current economic literature to document the hidden costs of the US tax system. Beyond accounting costs, the study takes a broad look at other hidden costs and implications of taxation: lobbying to gain and maintain tax advantages; economy-wide costs as tax incentives alter work, leisure, savings, consumption, production, and investments; and lost revenues as a result of taxpayer noncompliance.

The study finds that Americans face up to nearly $1 trillion annually in hidden tax-compliance costs, while the Treasury forgoes approximately $450 billion per year in unreported taxes.

KEY POINTS

According to the National Taxpayer Advocate, there were 4,428 changes to the Internal Revenue Code between 2001 and 2010, including an estimated 579 changes in 2010 alone. The tax code averages more than one change per day. The resulting complexity creates hidden compliance costs between $215 billion and $987 billion annually. To put this in perspective, total revenue collected by the federal government in 2012 was $2.5 trillion.

Accounting Costs

  • Americans spend an estimated between $67 billion and $378 billion annually in accounting costs related to filing taxes. Americans spent more than 6 billion hours (2011) complying with the tax code. This represents an annual workforce of 3.4 million—a population that could be the third largest city in the United States, surpassing Chicago (2,707,120), Houston (2,145,146), and Philadelphia (1,536,471), and larger than the population of 21 states. A workforce equivalent to that employed by the four largest US companies—Walmart, IBM, McDonald’s and Target—combined.

Economic Costs

  • The impact of taxes on the economy extends beyond the revenue taken by the government. The compliance burden results in estimates of foregone economic growth from $148 billion to $609 billion annually.

Lobbying Costs

  • While an estimate for tax lobbying specifically, is not available, lobbyists spent nearly $28 billion petitioning federal, state, and local governments for policy preferences between 2002 and 2011.

Lost Revenue

  • The United States has a tax-reporting compliance rate of 85.5 percent—leaving a 2012 revenue gap of $452 billion in unreported taxes, some of which is can be attributed to complexities in the tax code.

SUMMARY

Accounting Expenses and Economic Distortions

In 2011, there were 173 different tax deductions and credits for individuals and corporations that amounted to around 7 percent of GDP. The economic costs of these tax provisions and marginal rates are estimated between $148 billion and $609 billion.

Itemized Deductions:

  • Nearly one-third US taxpayers itemize specific tax deductions. This increases the costs of filing taxes, and distorts prices of goods and services ranging from homes to medical care.
  • In a 2011 study (using 2006 tax data), the IRS estimated individuals spent more than 3 billion hours complying with personal deductions.
  • The IRS also estimated businesses spent nearly 3 billion hours complying with deductions.

Corporate Tax Code:

  • The deductibility of interest payments also provides incentives for companies to load up on debt, rather than issue stock, to finance new business ventures.
  • Larger companies possess the resources and scale to more easily comply with a complicated depreciation schedule for capital investments than smaller companies. Further, while recent changes to the depreciation schedule under the American Taxpayer Relief Act provides more favorable treatment to both small and large firms, the provision favors capital intensive firms over those that are more labor intensive.

Tax Avoidance

Tax avoidance occurs when individuals or businesses adjust consumption and savings patterns in order to reduce tax burdens. This results in forgone economic transactions—or “deadweight loss”—that would have increased standards of living: the vacation not taken, the food not purchased, and so on. Estimates of this foregone invest- ment and consumption range from $148 billion to $609 billion.

Gaining and Protecting Current Tax Advantages

Lobbyists spent more than $27 billion to petition federal, state and local governments between 2002 and 2011. While not all of this lobbying was related to obtaining and protecting tax advantages, research confirms a strong relationship between lobbying expenditures and changes in tax policy.

A 2009 study found:

  • Each additional dollar spent on lobbying translated into $6 to $20 of tax benefits.
  • Firms that increase lobbying expenditures by one percent reduce their effective tax rates by an amount in the range of 0.5 to 1.6 percentage points the following year

Complying with Complexity—The IRS

According to the National Taxpayer Advocate—part of the Internal Revenue Service—the IRS itself cannot meet the needs of taxpayers who attempt to contact the agency.

  • Of the 115 million phone calls the IRS received in fiscal year 2012, it was only able to answer (actually pick-up) 68 percent of the calls, down from an 87-percent pickup rate in 2004.
  • The IRS also failed to respond to almost half (48 percent) of all taxpayer letters within the agency’s own established time frame—a dramatic increase from the 12 percent rate in 2004.
  • The US Treasury Inspector General’s semiannual report to Congress (2011) found that most taxpayers who contact the IRS do not receive quality responses to their correspondence. It cited
  • a review of three IRS functions—the Accounts Management function, Automated Underreporter Program, and Field Assistance Office—where 19 percent, 56 percent and 8 percent, respectively, of correspondents received both timely and accurate responses.

POLICY RECOMMENDATIONS

US history and international reform can guide legislators to reduce the staggering compliance costs of the overly complex tax code. Reform must significantly reduce or eliminate special tax provisions and lower rates. A simplified tax code will yield a more equitable, higher-performance economy with more federal revenues while reducing economic and accounting burdens.

The Tax Reform Act of 1986 was passed with significant bipartisan support and was the first tax reform in US his- tory to replace a significant number of tax expenditures by lower tax rates on individuals. Federal Reserve Bank economist Anil Kumar found (2007) that TRA86 reduced deadweight losses as a percentage of taxes by 6 percent. Studies estimate that US revenue lost from individual and corporate overseas tax evasion alone is between $50 billion and $130 billion.

The Costs of Tax Policy Uncertainty And the Need for Tax Reform

February 26, 2013

I. Introduction

The American Taxpayer Relief Act of 2012 (ATRA, P.L. 112-240) may be more significant for what it does not do than for what it does. Hopes for a ‘‘grand bargain’’ were not realized. In fact, ATRA does (almost) nothing to address the major fiscal problems that the United States continues to face.

No one seems pleased with ATRA. Noticeably absent were the self-congratulations among members of Congress that usually accompany the passage of significant legislation[1] — and for good reason. Even the bill’s title leaves something to be desired. The ‘‘Act of 2012’’ was not passed by Congress until 2013.

The primary focus here is not on the broader merits or demerits of ATRA, but rather on the issue of tax policy uncertainty. The fiscal cliff represented an extreme case of (manufactured) policy uncertainty. A growing body of research suggests that policy uncertainty imposes substantial economic costs in and of itself. ATRA substantially lessened U.S. tax policy uncertainty over the very short term by, for the most part, making permanent the Bush tax cuts.

However, all is not well. Policy uncertainty re- mains high. Under ATRA, added revenue will come from taxpayers at the top of the income distribution, but that will barely make a dent in the deficits that the United States has been running. Based on projections from the Congressional Budget Office, the Joint Committee on Taxation and the Office of Management and Budget, Veronique de Rugy shows that (over the next 10 years) ATRA is expected to add $332 billion in spending and $620 billion in added revenues. By contrast, projected deficit spending over the same 10 years is order of magnitudes larger than the projected deficit reductions from ATRA.[2] A strong recovery from the Great Recession would be a big help, but major structural problems would still remain.

Post ATRA, the problem of sequestration remains front and center. ATRA extended the start date for sequestration called for in the Budget Control Act of 2011 from January 1 to March 1. Even those wanting to cut the budget do not want to do so in the Procrustean manner laid out in current law. Thus, those cuts are unlikely to materialize, but what will take their place is anyone’s guess.

The Affordable Care Act (ACA) also remains a source of some tax policy uncertainty. As enacted, the individual mandate is set to start at the beginning of 2014. However, the tax is so low that it will be advantageous for many uninsured individuals to pay the tax and forgo insurance until they need it.[3] For the health insurance exchanges to function well and keep costs down, it will likely be necessary to substantially raise taxes from the individual man- date.[4] The only thing that is certain is that any debate over the tax issue will be contentious and heated.

Over the longer term, uncertainty looms. In the coming decades, the U.S. federal tax system is expected to bring in far less revenue than Congress is projected to spend. Major changes are needed to rein in programs such as Medicare, Medicaid, and Social Security, or major tax increases are needed — or a combination of the two approaches. Longtime budget expert Robert Reischauer (who served as director of the CBO and president of the Urban Institute) has said, ‘‘The path we’re on can’t go on for fifteen years. Whether it can go on for two, three, or four years, I have no idea.’’[5]

That near- and longer-term uncertainty is not good for the economy. Research is finding that uncertainty in and of itself has negative implications for the economy, slowing economic growth and possibly prolonging a weak recovery. Policy uncertainty has been shown to reduce investment and to cause companies and individuals to misallocate resources. All those things impose costs on society.[6]

A recent paper found that policy uncertainty could explain the United States’ poor economic performance in recent years.[7] The authors predict that policy uncertainty similar to what their measures show the United States has faced in recent years will result in a reduction in real GDP by 2.2 percent and a loss of 2.5 million jobs. The costs of uncertainty should be distinguished from the fact that uncertainty may arise from increased prospects for harmful policies. In recent years, those two factors (that is, uncertainty itself and the increased likelihood of inferior economic policy) have often been positively correlated. While policy uncertainty imposes economic costs, so too does a shift toward a bad policy environment.[8]

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Businesses Are Spending on Lobbying Instead of Jobs

Tuesday, December 11, 2012

It's well known that economic uncertainty slows growth, decreases investment, and destroys jobs. But a new study identifies an additional cost of uncertainty: businesses are diverting money away from expanding and hiring to lobbying Washington for preferential tax treatment. And with good reason. As tax increases loom over the fiscal cliff and beyond, many businesses may get more bang-for-the-buck hiring well-connected lobbyists than innovative engineers.

In a recent study for the Mercatus Center, a colleague and I found that the complex and increasingly temporary nature of the federal tax code invites special interest groups to lobby for favor. To remain financially competitive, businesses must work constantly to secure the same (or better) tax benefits as their competitors. As the tax code is constantly changing, this cycle of chasing better tax treatment never ends as the have-nots pursue the benefits of indulged special interests. Otherwise, losing the Washington tax-benefit game may mean losing your business: the industry battle to attract investors increasingly depends on ensuring these special tax rates.

The focus on satisfying consumers with new products and services, the crux of entrepreneurship, has consequently taken second place to preserving political privileges in the tax code. In the race to keep up with industry Joneses, American businesses are spending an ever-increasing amount of resources on lobbying and acquiring political information. Consequently, this type of unproductive entrepreneurship is drowning out productive business activities, such as research and hiring. This political activism is reshaping the character of what it means to be an entrepreneur.

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