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A Taxing Trend: The Rise in Complexity, Forms, and Paperwork Burdens
NTU Policy Paper No. 116
April 14, 2005
Like old age, tax complexity has been creeping up on us. We may not notice it one year at a time, but a review of older tax documents reveals just how shockingly complicated taxes have become today.
The 1040 form is often filed with Schedules A, B, and D, where taxpayers report itemized deductions, interest and dividend income, and capital gains. These four common forms now take an estimated 26 hours and 48 minutes to prepare. The 1040A, or "short" form, and its Schedule 1 now take nearly as long to prepare, at 11 hours and 21 minutes, as the "long" form of just nine years ago did.
Today's short form, at 48 lines, has double the number of lines on the 1945 version of the standard 1040 tax return.
The increase in the tax law's complexity alone has added roughly 1 billion hours in annual paperwork burdens over the last 10 years.
Line by Line, Complexity Is Moving Upward
Let's begin our tour of the tax law's complexity by looking at the growth of Form 1040 over the years. Sixty-nine years ago its instructions were just two pages long. Even when the income tax became a mass tax during World War II, the instructions took just four pages. Today taxpayers must wade through 128 pages of instructions, over triple the number in 1975 and more than double the number in 1985, the year before taxes were "simplified."
Form 1040 - Form and Instructions
If anything, this table understates the growing complexity of the form. For example, this year many "lines" have their own sub-lines for parts a, b, c, or even d. The form also asks for information without numbering the line item, such as check boxes for Presidential campaign funding and a personal ID number you select for a "third party designee" if you want the IRS to ask someone else about what you filed on your tax return.
If you need help beyond the basic form, the IRS now prints over 1,000 publications, forms, and instructions.
Paid Professionals Now Prepare Most Tax Returns
As the tax system's complexity has grown, more taxpayers are turning to their computers or running to tax professionals to prepare their returns. The number of taxpayers using paid professionals has soared by approximately 60% since 1980 and by nearly 30% since 1990. While some of this increase can be attributed to rising incomes, most of it is likely due to complexity.
The growth in the use of paid preparers can be accurately tracked because beginning in 1977 tax professionals have been required to sign returns they have been paid to prepare.
Tax Returns Signed by Paid Preparers
Between 1966 and 1977, anyone who prepared a return was required to sign it in addition to the taxpayer, meaning many unpaid relatives or friends signed the returns. Therefore, the data for the first few years probably overstates paid-preparer participation, because undoubtedly many unpaid people who had signed returns for years kept doing so even after the law had changed.
Tax preparation software has grown in sophistication, enabling more taxpayers to sit in front of a computer and answer a seemingly endless stream of questions while the computer figures out how to prepare the return.
In 1980 no individual taxpayers used computers to prepare their taxes. Yet today, when accounting for paid preparers and computer returns combined, about 90% of all returns are prepared with such assistance.
Use of Paid Preparers and Computers
Tax Preparation Fees Are Rising Too
Tax preparation fees have also increased substantially, largely due to increased complexity of the average tax return. One way of tracking the trend in fees is to examine the average fees charged by H&R Block, a publicly-traded company. It is the nation's largest tax preparation firm, and alone accounts for about one in seven tax returns filed by all Americans.
This year the company boasted that its "average fee per client served in company-owned and -franchised offices rose 6.7 percent to $145.08." Between 1980 and 2004, the average H&R Block tax preparation fee increased 430%, or 117% after accounting for inflation.
The rise in fees has occurred despite a huge increase in the capability of tax return software and speed of printers, which may have temporarily cut the inflation-adjusted cost of tax preparation in the late 1980s and early 1990s. The efficiency gain of computers and printers has likely been overwhelmed by the increases in complexity.
Average Fee Charged by H&R Block
Tax Complexity to Get Worse
Tax complexity probably will get worse before it gets better. Although the tax relief legislation signed into law in 2001 and 2003 cut tax rates, both increased complexity. The expiration dates of many tax cut provisions and the 2001 law's long phase-out of the death tax will cause new tax planning headaches.
Worst of all is the growing prospect that by 2010, more than 30 million taxpayers will be forced to complete a second tax return for the Alternative Minimum Tax (AMT), a parallel and complex tax system once aimed at ensuring the rich paid a substantial tax bill. As if one tax return wasn't difficult enough already.
This tax complexity monster is already striking unsuspecting taxpayers, some earning less than $50,000 per year. The IRS National Taxpayer Advocate notes that the AMT is "so complicated that many taxpayers are not aware that they may be subject to it."
In many cases taxpayers must decipher a separate instruction booklet, then fill out a 55-line form, only to discover they don't owe the AMT. This exercise is a major detour in tax preparation, with an estimated paperwork burden of 3 hours, 53 minutes for this one form alone. No wonder over 80% of taxpayers who owed the AMT paid a tax pro to compute their taxes.
Even the tax pros complain about this strange and complicated tax. The National Association of Enrolled Agents, the leading tax preparation trade group, has labeled the AMT as the most complicated aspect of the tax law, and gave it the "Tax Headache of the Year" citation during 2000 and 2001.
Despite the fact that tax rate brackets, personal exemptions, and the standard deduction rise with inflation, the AMT tax structure remains frozen. With each passing year, the AMT identifies a growing number of taxpayers as "rich" even though their real income hasn't changed. In the fall of 2004 Congress extended minimal AMT protections (such as a $58,000 exemption for married taxpayers filing jointly), but only for one year. By 2006, AMT liabilities – already headed upwards due to other factors – will soar.
The best solution for the AMT is to simply get rid of it altogether, a solution even recommended by the IRS National Taxpayer Advocate. But if Congress can't or won't do that, then it should at least adjust the tax's application for income growth to avoid a tax complexity nightmare for taxpayers and the IRS.
Federal Law Orders Cut in Paperwork, but Tax Paperwork Burden Rises
In an attempt to bring the paperwork burden under control Congress passed the Paperwork Reduction Act of 1995. According to the Office of Management and Budget, the new law "set an annual government-wide goal for the reduction of the total information collection burden of 10% during each of Fiscal Years 1996 and 1997 and 5% during each of Fiscal Years 1998 through 2001. The baseline is the total burden of information collections as of the end of FY 1995."
By that measurement, the law has been a failure, largely due to the increasing burdens at the IRS.
An earlier Paperwork Reduction Act passed in 1980 required federal agencies to track the paperwork burden imposed on citizens and businesses by their forms and recordkeeping requirements. In order to comply with the law, the IRS commissioned Arthur D. Little to undertake a comprehensive estimate of tax compliance costs for the tax year 1983. This survey served as the basis for the methodology used to track tax paperwork burdens that the IRS finalized with the 1988 tax year.
While the Little study is by far the most comprehensive available, James Payne estimated in his 1993 book Costly Returns that even it may understate the real burden –"perhaps by about 20-30%."
Recently the government has begun separately publishing paperwork burdens for the IRS. According to the Office of Management and Budget's FY 2004 Information Collection Budget of the United States Government, the "Internal Revenue Service (IRS) paperwork [burden] is currently estimated to total approximately 6.5 billion hours … [and] towers over the entire paperwork burden for the rest of the federal government..." Tax form paperwork burdens alone account for 80% of the total federal paperwork load.
Paperwork Burden Hours
If the Treasury Department were to reduce its burden by the average amount mandated by the 1995 Paperwork Reduction Act, the burden would have declined to 3.702 billion hours in 2000. Instead, the Treasury overshot that target by 2.454 billion hours.
Paperwork burdens aren't the result of IRS bureaucrats mindlessly dreaming up new forms and regulations. Much of the burden increase is due to a flood of new tax laws, including the Taxpayer Relief Act of 1997, the Economic Growth and Tax Relief Reconciliation Act of 2001, and the Jobs Growth and Tax Relief Reconciliation Act of 2003. These laws did reduce tax bills for middle class taxpayers, but significantly increased their paperwork burdens. For example, the 2003 tax cut law piled on another 38 million hours during FY 2003 alone.
Although the chart may indicate a decline in paperwork burdens between 2002 and 2003, this drop consists largely of factors not related to policy decisions – essentially, a slowing economy likewise reduced the filing of tax returns and therefore the aggregate burden. As the Office of Management and Budget's FY 2004 report indicates:
Indeed, even as overall burdens declined between 2002 and 2003, the burden attributable to actual "program changes" rose by some 37 million hours.
These figures apparently only account for the time spent in keeping the necessary records and learning about and complying with the law. Yet, a significant additional but uncounted burden comes from trying to exploit the law's loopholes to the maximum extent. For example, millions of citizens subscribe to personal finance publications and much of the advice offered deals with taxes. Taxpayers are often advised to consider the tax consequences of any major financial transaction, and this form of tax planning undoubtedly adds many millions of hours to the time spent coping with the tax system.
It's Taking Longer to Prepare and File Tax Returns
Despite the passage of the 1995 Paperwork Reduction Act, the time it takes to file commonly-used individual income tax forms has increased.
The 1040 form is often filed with Schedules A, B, and D, where taxpayers report itemized deductions, interest and dividend income, and capital gains, respectively. From 1988, when the IRS started tracking this information, to 2004, the average paperwork burden hours climbed from 17 hours and 7 minutes to 26 hours and 48 minutes, an increase of 57%. The time burden has increased by 26% since 1995.
History of Estimated Preparation Time, 1040 Form and Common Schedules
Even the short forms are much more complicated. The 1040EZ form, the simplest in the IRS inventory, now requires 3 hours and 46 minutes, up from 1 hour and 31 minutes in 1988, a jump of 148%. The 1040A and Schedule 1 (interest and dividend income) has seen a paperwork burden increase of 44% since 1995.
History of Estimated Preparation Time, 1040A Forms
History of Estimated Preparation Time, 1040EZ Form
The Tax Code is so convoluted that no one inside or outside the IRS understands it. For many years Money magazine's annual test of tax preparers for a hypothetical household proved that paid professionals often make huge mistakes. In 1998, the last year Money administered the test, all 46 tested tax professionals got a different answer, and not one got it right. The pro who directed the test admitted "that his computation is not the only possible correct answer" since the tax law is so murky. The tax computed by these pros "ranged from $34,240 to $68,912." The closest answer still erred in the government's favor by $610.
No wonder taxpayers themselves, the majority of whom rely on preparers, fare little better when asked basic tax questions. According to a CCH CompleteTax online poll conducted by Harris Interactive, "more than two-thirds of respondents overall answered survey questions incorrectly when asked about issues that may arise during the course of doing their taxes this year." The survey, conducted February 18-22, 2005, recorded responses from 2,244 U.S. adults who had filed a federal tax return within the past two years. Among the results:
While the 1998 IRS Restructuring and Reform Act requires Congress to at least consider complexity before passing tax legislation, that has not provided enough incentive for Congress to avoid additional complexity or encourage simplification. The tax-writing committees should be required to quantify the burdens of proposals that add complexity or the savings from proposals that simplify the law.
The National Commission on Restructuring the IRS suggested that Congress consider a quadrennial simplification process, and Congress and the President should implement such a process either through legislation or by executive order. The Commission found that many members of the private sector tax community were willing to volunteer substantial time to make suggestions for simplification.
A quadrennial simplification commission would harness this volunteer activity and give a broad group of people much more incentive to work for the adoption of simplification rules. This quadrennial commission would also give the Joint Committee on Taxation and the Treasury Department more incentive to suggest simplification of the law.
Conclusion: A New Approach to Taxes Is Needed
Fundamental overhaul of our tax system remains a critically-important goal. As the Internal Revenue Code becomes increasingly incomprehensible, the intrusive measures provided to the IRS for enforcing it seem to become more draconian. Every detail of a taxpayer's private financial life is open for government inspection. IRS employees can make extraordinary demands on taxpayers, and can take extraordinary actions against them. Mixing such broad powers with a vague and complex law is a recipe for a civil liberty catastrophe. The threat of abuse is always present.
As the President's Advisory Panel on Federal Tax Reform prepares its report for release this summer, policymakers should bear in mind the tremendous burden that tax complexity imposes on the process of filing as well as paying taxes. Until we change how we tax income, we will continue to have an intrusive agency with broad powers. It doesn't have to be that way. Our economy as well as our civil liberties would be better off with fundamental tax reform.