Wednesday, January 21, 2009

Income Tax Reform

While surprisingly there was little discussion of it in last year's presidential campaigns, our current system of federal income taxation is ridiculous and badly needs to be reformed. The system is unnecessarily complex, too expensive, compliance is difficult to effectively monitor, and its complexity and loopholes unfairly favors the wealthy and other upper income individuals and larger businesses who can much better afford high-priced tax attorneys and accountants.

What's the evidence? Its virtually endless, but for starters President Obama's bright and experienced nominee for Treasury Secretary, Tim Geithner, who will oversee the Internal Revenue Service, made some embarrassing mistakes with his tax returns and has taken heat from this in recent testimony on his nomination in the Congress. The tax code, including associated regulations, now runs more than 60,000 pages, 500 changes having been made last year alone. This compares with 400 pages when the federal income tax was introduced in 1913.
The IRS offers more than 400 different forms and more than 100 instruction booklets to explain how to complete them.

The IRS' national taxpayer advocate has estimated that the complexity of the tax code results in taxpayers spending roughly $193 billion annually complying with filing requirements, equivalent to 14% of all income taxes collected! Reportedly, about 60% of taxpayers feel it's necessary to pay a professional, generally a tax attorney or accountant, to handle their tax returns. Another 22% of Americans apparently purchase tax return preparation software, like TurboTax. That means that only 18% of Americans are comfortable preparing their own returns.

According to an article written by a credible business executive in 1998, individuals spent an estimated total of 1.7 billion hours annually preparing tax returns and business owners spent an additional 3.4 billion hours. That was 10 years ago when the tax code was shorter in length and somewhat simpler. No doubt the hours spent in more recent years are much greater.

The clear conclusion by almost everyone, including most members of Congress, but probably excluding tax attorneys and accountants who specialize in making a good living by preparing tax returns for their clients, and who lobby for something close to the status quo, is that serious tax reform, especially much greater simplicity, is greatly needed. Why, then, has there been so little meaningful and effective action? It's a fair question. I think the answer is the fact that there have been so many other issues deemed to be priorities, partisanship and gridlock in the Congress, legitimate differences of opinion about how to tackle the issue, and the lobbying by the attorneys and accountants. Another factor is probably that there has been relatively little political pressure from voters and the media to act.

A number of general proposals have been brought up, including a flat tax of 20-21% and a so-called "fair tax" under which the income taxes would be abolished and instead we would have a federal sales tax of about 23%. A problem with the flat tax is that it would be likely to increase taxes for the poor and middle class and reduce taxes paid by upper income and wealthy Americans. A problem with the "fair tax" is that state and local taxes would come on top of the federal sales or consumption tax.

Whatever the final solution, the bottom line is we need to reform the tax system in a way that makes tax return preparation and filing much simpler, less time-consuming and less costly, but the new system must be fair and sustainable, with compliance much easier to monitor. Furthermore, the system needs to be able to generate adequate tax revenues to cover the legitimate needs of an efficient federal government with a fully balanced budget.

Many individuals should be able make do with a one page form and most individuals should be able to use a return of no more than two or three pages that they can complete themselves. I would think that the preferred solution will involve abolishment of our current tax code and the associated regulations as well as the IRS as we now know it, with its roughly 100,000 employees and annual budget of around $10 billion.

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