America's Tax System: Complex, Convoluted, and Costly
With just about two months until Tax Day, those taxpayers who have already started work on their 1040s or 1099s are likely feeling the strain from America’s overly-complicated tax system. Last year’s onerous requirements were highlighted in National Taxpayers Union’s Taxing Trends study* which showed how our hybrid progressive income-based system costs almost $32 billion each year in software, preparation, and other compliance-related expenses and 6.1 billion hours – the equivalent of $193 billion in forgone wages – just to comply with the law.
Even though one might expect that these costs would shock politicians into action, there has been a lot of talk but little progress on comprehensive tax reform. Instead the Tax Code has grown. There are over 14,000 pages of tax regulations and rules that individuals and small businesses must navigate or spend money on tax preparers in hopes of not getting fined or audited by the Internal Revenue Service (IRS). Much of the growth stems from regulations imposed by larger bills such as the Patients Protection and Affordable Care Act as well as the Dodd-Frank Wall Street Reform and Consumer Protection Act, but even smaller proposals can add new layers to the already bloated requirements.
From Congressman Paul Ryan (R-WI) to Senator Elizabeth Warren (D-MA), many legislators have called for simplifying the Tax Code. Americans would be better served by a system that is not too overbearing, expensive, or complicated and can work amidst changing economic conditions and government funding needs. As a response, two reform paths have been proposed by Members of Congress. One is to maintain the current system but with fewer credits, subsidies, and exemptions. The other is to scrap the entire system in favor of a new, more efficient form of taxation.
In this week’s Taxpayer’s Tab, we will look at recently scored legislation under the BillTally system to compare bills that would adjust or scrap today’s Tax Code.
* This year, NTU Foundation will be taking over the annual Taxing Trends study with a fresh look at how our tax system costs billions in dollars and time spent. Check out past studies and stay tuned for details.
The U.S. currently administers what is called a progressive income tax system. In general, the more that one earns, the higher percentage of their income will be taxed. For example, someone making $35,000 per year will be taxed at a lower rate compared to someone making $140,000. The reasoning behind the different rates is that higher-income earners can pay more because their living expenses represent a lower percentage of their income. The less you make the larger proportion you spend on necessities.
The system has thousands of deductions, credits, and exemptions. These are special conditions that apply to individuals or businesses, such as how many children live in a household, whether a child is adopted, or if a company buys energy efficient appliances for a factory. And nearly every year, Congress considers what to do about dozens of so-called “extenders” – very specific provisions that were designed to offer temporary relief for some taxpayers, yet are often extended for several years beyond the original time frame or even permanently. In December, Congress enacted some 50 of these extenders representing $42 billion in revenue; more are being considered this week. Because there are so many different variables that effect one’s total tax obligation, the code must explain all of them and set out rules determining when they apply. This is where the 14,000-page code grows and expands.
Reforming Today’s SystemIn many policy areas, Members of Congress tend to strive for small, incremental changes, perhaps because they are more politically and logistically feasible than comprehensive reform; however, some in Congress have proposed fundamental reforms that would have wide-ranging effects on the economy. Two specific measures would simplify or eliminate the progressive tax brackets while limiting the number of credits that one can claim each year.
Former Congressman Dave Camp (R-MI) offered a blueprint that resembles the current system, but with simpler parameters. The Tax Reform Act was introduced as a committee draft document last year and would eliminate 25 percent of the existing tax code by cutting the number of individual brackets down from seven to two (either 10 or 25 percent of taxable income) and offering a higher standard deduction, reducing the need for many Americans to itemize their own. It would also repeal several existing credits while expanding eligibility for others. While the total extent of the draft’s impact on federal outlays remains unclear, it did specifically allocate $127 billion over eight years to infrastructure projects, and would likely reduce administrative costs for the IRS.
Senator Richard Shelby (R-AL) has introduced legislation that takes the idea of “simplification” even further. His Simplified, Manageable, and Responsive Tax (SMART) Act was most recently introduced in the 113th Congress as S. 173 (but not yet in the current Congress), and would institute a system in which all filers would pay at a single rate: 17 percent. The income tax would only apply to individuals making more than $13,410 and households earning at least $17,120, and the bill would eliminate all income tax credits for a one-year savings of $86 billion.
A Consumption-Based SystemWhile the Camp proposal and the SMART Act would modify the existing system that taxpayers are all-too-familiar with, a related measure would take tax reform in a different direction. The Fair Tax Act would completely replace the income-based system with a consumption-based tax. Rather than filling out a tax return every year, Americans would pay their federal taxes whenever they purchase goods and services, right at the cash register or point-of-sale.
Sponsored in both chambers by Congressman Rob Woodall (R-GA) and Senator Jerry Moran (R-KS), the Act would repeal all income-based taxes, including those on withholdings, capital gains, dividends, and corporate income. The decrease in the embedded cost of products has been estimated at about 23 percent. This is an embedded cost, which exists because producers pass on tax expenses to consumers – in other words, the gallon of milk or haircut you pay for already has this 23 percent expense accounted for in the final sale price. Under the Fair Tax plan, the federal government would impose that 23 percent tax-inclusive rate at the time of purchase of all new goods or services (other items would be excluded).
Whether buying essentials like food and water, or luxury items like a new watch or jewelry, the Fair Tax would impose the same tax on all goods without any exemptions. Yet, the bill would also establish a mechanism for reimbursing individuals or families a rebate for their taxes paid on necessities. Families would have to register to receive the monthly amount. The rebate would cover all taxes paid on purchases up to the federal poverty level. It is argued that this system is more efficient than having multiple exemptions and thousands of credits in the current system. The “pre-bate” would also reduce the effective tax rate for lower-income households to zero (or below), maintaining the progressive nature of the current system.
Under the plan, the Internal Revenue Service would be steadily down-sized and eventually eliminated. A new, smaller and less intrusive agency would be created to oversee the transactions and transfers. NTUF assumes that this entity would be comparable to the current Alcohol and Tobacco Tax and Trade Bureau.
Proponents of the Fair Tax maintain that the system is revenue-neutral (it would collect the same amount of tax revenue as the current system), but it would significantly alter government outlays. Delivery of the monthly rebates and the new agency would increase federal expenditures by up to $350 million* each year (costs could be reduced through use of debit cards or direct deposits to transfer the rebates). On the other hand, savings occur by dismantling the IRS and repealing refundable tax credits, totaling over $98.2 billion annually.
A refundable tax credit is a payment to an individual or household in excess of their tax liability. In other words, it is a credit that eligible filers receive as cash above and beyond their income tax liability and is recorded in the budget as outlays, i.e., spending.
If the Fair Tax Act is enacted, the government would save $96.4 billion over the next five years. Considering the greater economic implications, the costs of complying with the tax system would largely fall on businesses, leaving households to otherwise spend their tax preparation funds elsewhere.
* NTUF calculated the cost of the “pre-bates” by determining the cost of mailing a bulk-rate letter ($0.171) to every American household (123 million) each month. According to BillTally rules, the cost of the pre-bates themselves would count as a credit, which is counted as revenue.
Other OptionsIf gridlock continues in Washington, D.C. and the tax system continues to grow, taxpayers have a number of other solutions or alternatives, including a bill by Congressman Bob Goodlatte (R-VA). H.R. 27, the Tax Code Termination Act, which would terminate the Tax Code at the end of 2019 and declare that Congress must enact a new “simple and fair” system by July 4th of that year. Though the bill is conditional in nature and would not necessarily yield savings, it would instill a sense of urgency for Members who wish to make tax reform a reality. Similarly, Congressman David Cicilline’s (D-RI) H.R. 362, the Paying a Fair Share Act, expresses the sense of the Congress that tax reform is needed to repeal “unfair and unnecessary” tax loopholes. It also would institute a minimum 30 percent income tax above all other deductions and exemptions on all Americans making over $1 million in a year.
Regardless of which route Congress chooses to take, it’s clear that the costs of inaction on tax reform are growing at an alarming rate.
|The Bottom Line: Though it may appear that tax reform is beyond reach, there are many ideas already on the table, including changes to the current framework or wiping the slate clean and instituting an entirely new system. The choice is ultimately up to the Representatives and Senators on Capitol Hill, but NTUF will continue to track the costs associated with the legislation they debate and offer taxpayers the information they need to consider.|
National Taxpayers Union Foundation is a nonpartisan research and educational organization dedicated to helping Americans of all ages understand how taxes, government spending, and regulations affect them. Through our timely information, analysis, and commentary, we’re empowering citizens to engage in important policy debates and hold officials accountable.
Our findings are provided for educational purposes only and are not intended to aid or hinder the passage of legislation or as a comment on any Member’s or Candidate's fitness to serve. Photo Credits: Wiki Commons, Pixabay (Nemo)