Tax Simplification: Issues and Options

William G. Gale
William G. Gale The Arjay and Frances Fearing Miller Chair in Federal Economic Policy, Senior Fellow - Economic Studies, Co-Director - Urban-Brookings Tax Policy Center

September 10, 2001

I. Introduction

The notion that taxes should be simpler is one of the very few propositions in tax policy that generates almost universal agreement. The fundamental paradox of tax simplification is that despite this consensus, almost every year tax rules become more complex.

This report, based on recent congressional testimony, examines a broad range of issues regarding tax complexity. Section II discusses the costs, benefits, causes and sources of complexity. Simpler taxes have numerous benefits. They would reduce taxpayers’ costs of complying with the tax system in terms of time, money, and mental anguish. They would likely raise the use of tax subsidies—say, for education—reduce unintentional tax evasion, and increase the likelihood that taxpayers would see the tax system as fair. But simpler taxes also have costs. In particular, they reduce the ability of policy makers to achieve other goals of tax policy. Features of the tax code that are designed to increase tax equity, police intentional tax evasion, or encourage some particular activity often increase complexity. Thus, tax complexity arises in large part as the result of a trade-off between simplicity and other policy goals. As a result, the fundamental issue is not the overall level of complexity; rather, it is whether particular tax provisions (or tax systems or alternative means of providing government services, such as spending or regulations) provide good value for the complexity they create. This depends on the magnitude and incidence of the costs and benefits of complexity, where the benefits include the extent to which complexity aids in achieving other policy goals. Moreover, many of the factors that generate complex tax systems—policy trade-offs, politics, and taxpayers’ desire to reduce their own tax burdens—are not features of particular tax policies per se. They will likely remain in force even if the tax system were reformed or replaced. As a result, an analysis of the extent to which policy changes can affect tax complexity should incorporate these factors.

Section III discusses how the president’s tax cut affects the complexity of the existing tax system and the prospects for future simplification efforts. The new tax law provided a few simplifying measures (with espect to the EITC, the repeal of limitations on itemized deductions and personal exemptions, and the reduction in marginal tax rates). On net, however, the new law made taxes much more complex and made tax planning much more difficult. This is a result of the “sunset” provisions, the long and variable phase-ins and abrupt phaseouts of numerous provisions, the failure to address the long-term AMT problem and the willingness of the administration and the Congress to increase the severity of that problem, complicated provisions regarding the estate tax, and an increase in targeted subsidies in education and retirement saving. Perhaps even more troubling, the new law also substantially reduced future prospects for simplification because it allocated such a large share of projected budget surpluses toward other uses, and because politically viable simplification often requires reduced tax revenues to ensure that there are few losers from the reform.

Section IV discusses principles and options for reform in the existing system. The key to tax simplification is to make fewer distinctions across economic activities and personal characteristics. Taxes should be imposed on a broad base at relatively low rates that do not vary by income source or expenditure type. Progressivity should be embodied in the rate structure and the tax base, not in the design of specific provisions. Universal exemptions, deductions, or credits are much simpler than targeted ones. The following types of reforms could make taxes simpler as well as fairer and more conducive to economic growth: addressing the uncertainty created by sunset and phase-out provisions of EGTRRA; reforming the individual AMT; eliminating (or at least coordinating) phaseouts of tax credits; coordinating and consolidating provisions with similar purposes (including provisions aimed at low-income families with children, retirement saving, and education); and reducing the top tax rates in conjunction with taxing capital gains as ordinary income. Filing and record keeping could be simplified by consideration of “return-free” tax systems, and by significantly raising the standard deduction.

Section V investigates the costs of tax complexity in the current tax system. Reliable estimates of the costs of compliance, administration, and enforcement of the income tax vary widely, due in part to inadequate data. The best estimate is that, in 1995, those costs ranged between $75 billion and $130 billion, or between 10 and 17 percent of revenues. These costs are distributed mainly to taxpayers in higher income groups. There is wide disagreement on the compliance costs of the estate tax, but the more reliable estimates place those costs at about 10 percent of revenues.

Sections VI and VII examine tax complexity and fundamental tax reform. Some have turned to new tax systems—such as a flat tax or a national retail sales tax (NRST)—as an alternative way to simplify taxes. In their idealized form, these taxes are extremely simple. But a crucial caveat is that no country has successfully enacted or administered a high-rate national retail sales tax or a flat tax. The features of tax systems that exist in the real world have been forged through a combination of revenue requirements, political pressures, responses to taxpayer avoidance and evasion, lobbying, and other processes that any operating tax system would eventually have to face. Notably, all of these factors tend to raise complexity. In contrast, tax systems that exist only on paper—such as the NRST and the flat tax—appear simpler in significant part because they have not had to face real-world tests.

Section VIII is a short conclusion. Tax simplification is a long-standing issue that garners widespread support, at least in principle, and is technically feasible. But the fact that most existing taxes turn out to be far more complex than originally proposed should serve as a caveat to the view that achieving tax simplification, in the existing or a new tax system, will prove easy or durable.