Testimony

Tax Simplification: Issues and Options

William G. Gale

Mr. Chairman and Members of the Committee:

Thank you for providing me with the opportunity to present my views on issues and options related to simplification of the tax code. My testimony is divided into two sections. The first provides a summary of my principal conclusions; the second provides the economic analysis that supports these views.

Summary

Basic Issues

  • The notion that taxes should be simpler is one of the very few propositions in tax policy that generates universal agreement. The fundamental paradox of tax simplification is that, although everyone thinks taxes should be simpler, almost every year tax policy becomes more complex. This suggests that pleas for simplification need to be buttressed by an understanding of the causes of complexity and the likely outcome of simplification efforts.

  • 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 increase tax equity, police intentional tax evasion, or encourage some particular activity often increase complexity.

  • These considerations of the costs and benefits of simplification have several implications for thinking about tax complexity:

    —Tax complexity arises in large part as the result of a trade-off between simplicity and other goals.

    —As a result, the fundamental issue is not the overall level of complexity; rather it is whether particular tax provisions, 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.

    —Moreoever, 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.

Simplification and EGTRRA

  • The new tax law provided a few simplifying measures (with respect to the EITC, the repeal of limitations on itemized deductions and personal exemptions, and the reduction in marginal tax rates).

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  • 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 phase-outs of numerous provisions, the failure to address the long-term AMT problem and the willingness to increase the severity of that problem, complicated provisions regarding the estate tax, and an increase in targeted subsidies in education and retirement saving.

  • 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.

Directions for simplifying taxes

  • 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) phase-outs 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 enhanced by consideration of “return-free” tax systems, and by significantly raising the standard deduction.

Estimates of complexity in the current 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 most reliable estimates place those costs at about 10 percent of revenues.

Complexity and fundamental tax reform

  • Some have turned to new tax systems-such as a flat tax or a national retail sales tax-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.

I. Tax Complexity: Some basics

A. Measuring complexity

Tax complexity has many dimensions and could plausibly be defined in different ways. Following Slemrod (1984), we define the complexity of a tax system as the sum of compliance costs-which are incurred directly by individuals and businesses-and administrative costs-which are incurred by government. Compliance costs include the time taxpayers spend preparing and filing tax forms, learning about the law, and maintaining record-keeping for tax purposes.

The costs also include expenditures of time and money by taxpayers to avoid or evade taxes, to have their taxes prepared by others, and to respond to audits, as well as any costs imposed on any third-parties, such as employers. Administrative costs, although incurred by government, are ultimately borne by individuals. These costs include the budget of the tax collection agency, and the tax-related budgets of other agencies that help administer tax programs.

Defining complexity as the total resource cost provides a quantitative measure by which different tax systems can be compared, and by which the administrative aspects of a particular tax system can be evaluated relative to its impacts on equity, efficiency, and revenue. But the definition is not ideal. Slemrod (1989a) points out that a particular subsidy could be so complicated that few taxpayers use it. If it were simplified, and enough additional people used the subsidy, total resource costs would rise, even though the subsidy itself had become less complicated.

A number of issues arise in efforts to measure tax complexity: First, permanent and transitory costs may differ. A new tax provision may raise compliance costs temporarily, as people learn about the change, even if it reduces costs in the long-term. Likewise, for administrative costs, the capital cost of upgrading IRS computers might appear as a current-year budget expenditure rather than being amortized over time. Second, only the incremental costs due to taxes should be included. Even with no taxes, firms would need to keep track of income and expenses to calculate profits, and individuals would engage in financial planning. This activity should be omitted from compliance cost measures. Third, an analysis of tax complexity alone may generate misleading conclusions. Governments can impose policies via taxes, spending, regulations, or mandates. Any tax provision can be made simpler by eliminating it, but if it then is recreated as a spending program, the overall complexity of government may rise.

B. Benefits of simpler taxes

Simpler taxes would be beneficial in a number of ways. First, simpler taxes would reduce taxpayers’ of complying with the tax system in terms of time, money, and mental anguish. By reducing these costs, simplification would reduce the overall burden of taxation.

Second, tax provisions that are simpler are more likely to be used. Provisions aimed at encouraging certain activities-such as saving for college-will be less likely to be used and hence less effective if people cannot understand how they work.

Third, making taxes simpler would probably raise compliance rates (i.e., reduce illegal tax evasion). To some (uncertain) extent, people do not pay taxes because they do not understand the tax law. Clarifying and simplifying tax rules can only help to make people understand the law better, and would likel

Finally, simpler taxes would generate more public support and thus should be an essential part of any effort to improve the delivery of government services. The biggest complaint about the tax system for many people is not the amount of taxes they pay but rather the sheer, and seemingly needless, complexity of what appear to be everyday tax situations (Graetz 1997).

C. Which features of the tax code generate complexity?

The level of complexity can be influenced by structural elements-such as the tax base, the tax rate structure, and the allowable deductions, exemptions, and credits-as well as by administrative features of the tax code. The three most discussed tax bases are income, wages, and consumption. Holding the other features of the tax system constant, income is the most difficult of the three bases to tax. Income may be decomposed into its sources-wages and capital income-or its uses-consumption and saving. For a wide variety of measurement and timing reasons, it is generally easier to tax wages than capital, and easier to tax consumption than saving.

Tax rates are typically either graduated, like the current income tax, or flat, like the payroll tax. Flat-rate taxes can have lower compliance costs than graduated taxes. The presence of graduated rates gives taxpayers incentives to avoid taxes by shifting income over time or across people. And flat-rate taxes allow more efficient administrative structures to function. Taxes imposed at flat rates can be easily collected at source, since the rate does not vary across taxpayers.

Exemptions, deductions or credits that are universal create little complexity. However, targeted provisions require clear definitions of eligible taxpayers and activities, and can create compliance headaches. Finally, different ways of administering taxes may affect complexity. For example, withholding taxes at source or eliminating the requirement to file a tax return could reduce compliance costs for individuals.

The discussion above suggests that, other things equal, the simplest system would tax consumption at a flat rate with universal deductions, credits or exemptions, and with withholding at source. Yet, the U.S. and many other countries tax income on a graduated basis, with numerous targeted credits and deductions, and with withholding at source only for certain types of income. Given the prevalence of these alternative systems, and absence of any country that taxes only in the simplest way described above, it is instructive to ask why existing systems deviate so strongly from the simplest structure.

D. Why are taxes complex?

Any plea for simpler taxes has to start by addressing a basic problem: If everyone thinks taxes should be simple, why are taxes so complicated? At least four factors help explain why taxes become complicated and suggest keys to making taxes simpler.

The first, and most important, is conflict among the consensus goals of tax policy. Although almost everyone agrees that taxes should be simple, most people also agree that taxes should be fair, conducive to economic prosperity, and enforceable. Even if all parties agree on these goals, they do not typically agree on the relative importance of each goal. As a result, policy outcomes usually represent efforts to balance one or more goals against the others. That is, sometimes a certain amount of complexity is created or permitted in order to help achieve other policy goals. For example, attempts to make taxes fairer often conflict with attempts to make taxes simpler. Most countries tailor tax burdens to the characteristics of individual taxpayers. This may improve tax equity, but it also creates complexity. It requires tracing income or consumption from the business sector to the individual. It requires reporting and documenting individual characteristics such as marital status, number of dependents, and age, as well as the composition of expenditures or income. It allows tax rates that vary with individual characteristics, creating opportunities for tax avoidance.

In this context, tax complexity is like air pollution: it is an unfortunate and undesirable consequence of products or services that we, as a society, desire. Just as the optimal level or air pollution is not zero-since that would mean that many of the goods and services society cherishes could not be produced-the optimal level of tax complexity is not zero. And just as we should seek the most efficient ways to reduce air pollution, we should also seek the most effective ways to make taxes simpler.

The second factor that generates tax complexity is the political process. Politicians and interest groups have interests in targeted subsidies that reduce taxes for particular groups or activities. But targeted subsidies inevitably make taxes more complex by creating more distinctions among taxpayers and among sources and uses of income.

Third, some complexity is necessary to deter tax avoidance. Taxpayers have every right to reduce their taxes by any legal means. But this activity inevitably raises questions about whether particular activities or expenditures qualify for tax-preferred status. The Treasury Department responds with complex rules designed to limit avoidance. Taxpayers in turn respond by inventing complex transactions to skirt the new rules. This can create a vicious cycle that leads to more and more complex rules and increasingly sophisticated and complex avoidance strategies.

Fourth, many complicated provisions were enacted to raise revenue or limit revenue losses during times of rampant budget deficits. For example, the landmark Tax Reform Act of 1986 (TRA)-a remarkable accomplishment in many respects-fell short of its goal of simplicity to meet the requirement of “revenue neutrality.” TRA created several complicated phase-outs and hidden taxes in order to raise revenue and meet distributional targets. Insofar as complexity has arisen from efforts to limit revenue loss, the surplus that existed at the beginning of this year and the political consensus in favor of some sort of tax cuts created an opportunity to simplify taxes. In that regard, and as discussed further below, the recent tax act is not only a missed opportunity for simplification, but may also have used up whatever funds would otherwise have been available to support simplification efforts.

E. Implications for thinking about tax simplification

Recognition of these factors has several important implications for the study of tax complexity.

  • First, the fundamental question is not the overall level of complexity, but whether particular tax provisions, 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.

  • Second, the factors that generate complex tax systems-policy trade-offs, politics, and taxpayers’ desire to reduce their own tax burdens-are not features of 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.

  • Third, there is an important distinction between private and social gains or costs. Suppose everyone had to fill out five extra lines of the tax form to receive a $1,000 tax cut. Each person might regard that as “good complexity,” worth the cost of providing extra information. But, holding tax revenues constant, the revenue would still have to be raised from somewhere, so the net tax cut would be zero—that is, everyone’s tax “cut” would be from a higher initial tax liability and net taxes would be the same. Thus, from a social perspective, the sum of all individuals’ “good complexity” could be zero or negative.

II. Simplification and the new tax law

A. Provisions

The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) was signed into law by President Bush on June 7, 2001.

Both the most important and most novel aspect of EGTRRA is the general provision that the entire bill “sunsets” at the end of 2010. All provisions of the bill are eliminated and the tax code at that point reverts to what it would have been had the tax bill never been passed.

The act also contains numerous specific provisions. Some of these are listed in table 1 and described here along with their effective phase-in and phase-out dates. They are listed in order of the tax cut provided when fully phased in.

  • Reduce marginal income tax rates of 28 percent or higher:

    The 28, 31, and 36 percent tax rates (which apply to married households with taxable income above $45,200, $109,250, and $166,500, respectively) will each fall by 3 percentage points, and the 39.6 percent top rate (which applies to married households with taxable income above $297,350) will fall to 35 percent. Each of these rates declines by 0.5 percentage points for tax years beginning after December 31, 2000, with further declines in 2004 and 2006.

  • Eliminate the estate tax:

    The effective exemption in the estate tax is raised from $675,000 currently to $1 million in 2002, and then gradually to $3.5 million in 2009. The top effective marginal tax rate is reduced from 60 percent currently to 50 percent in 2002 and then gradually to 45 percent in 2009. The credit for state-level estate taxes is gradually phased out between 2002 and 2005, after which it is replaced by a deduction. This change finances about one-quarter of the cost of the entire reduction in federal estate taxes. In 2010, the estate and generation-skipping transfer taxes are repealed, the highest gift tax rate is set equal to the top individual income tax rate, and the step-up in basis for inherited assets that have capital gains is repealed.

  • Create a new 10 percent income tax bracket:

    A new tax bracket of 10 percent is carved out of the first $6,000 of taxable income for singles, and the first $12,000 of taxable income for married couples. This income is currently taxed at a 15 percent rate. Starting in 2002, the 10 percent bracket is implemented by changing the tax rate and withholding schedules. In 2001, the 10 percent bracket is implemented by providing an advance credit for 2001 taxes. The advance credit is a one-time payment of the minimum of the taxpayer’s 2000 income tax payment (the payment due on April 15, 2001) or $300 ($600) for singles (married couples). This payment is intended to substitute for the 10 percent tax bracket in 2001, but for some taxpayers it will serve more as a rebate of the previous years’ taxes because taxpayers who do not owe taxes in 2001 but did owe them in 2000 will not have to repay the rebate they receive.

  • Increase and expand the child credit:

    The child credit is gradually increased, from $500 currently to $1,000 by 2010. The child credit is also made refundable to the extent of 10 percent of a taxpayers earned income above $10,000 for 2001-4 and 15 percent for subsequent years, with the $10,000 amount indexed for inflation. Refundability improves the access to, and amount of, child credit benefits for low-earning households.

  • Partially address the marriage penalty:

    The standard deduction for married couples gradually rises from 174 percent to 200 percent of the standard deduction for singles in the years 2005 to 2009. The top income level in the 15 percent bracket for married couples gradually rises from 180 percent to 200 percent of the similar level for singles from 2005 to 2008. The beginning and ending of the EITC phase-out will gradually increase by $3,000 by 2008, and will be indexed for inflation thereafter.

  • Repeal of limitations on itemized deductions and phase-outs of personal exemptions:

    The repeals are phased in between 2005 and 2009.

  • Pension and IRA provisions

    Contribution limits for Individual Retirement Accounts and Roth IRAs will rise to $5,000 by 2008 and be indexed for inflation thereafter. Contribution limits to 401(k)s and related plans will rise gradually to $15,000 in 2006 and then be indexed for inflation. Additional so-called “catch-up” contributions of up to $5,000 for anyone over the age of 50 will be permitted. Roth 401(k) plans can be established starting in 2006. A non-refundable credit for retirement saving for low-income taxpayers will be available between 2002 and 2006.

  • Education provisions

    Taxpayers may take an above-the-line deduction for qualified higher education expenses, but only for the years 2002 to 2005. Effective in 2002, the contribution limit on education IRAs rises to $2,000 from $500. The definition of qualified expenses from education IRAs is expanded. Pre-paid tuition programs will now benefit from tax-free withdrawals as long as the funds are used for education. Deductions for student loans are made more generous.

  • Temporarily, limited AMT relief

    Between 2001 and 2004, the exemption amount in the individual AMT is increased by $2,000 for single taxpayers and $4,000 for married taxpayers. This provision is abolished at the end of 2004.

B. Effects of EGTRRA on tax complexity

It would be an understatement to say that simplification was not one of the goals of EGTRRA. In fact, the overall net impact of the new tax law will be to make taxes more complicated over time.

There are three bright spots for simplification. First, for the earned income credit, the bill simplifies the definition of earned income, the definition of a qualifying child, and calculation of the credit. This is an important set of changes since it allows benefits to be provided to low-income household

Second, the bill repeals the limitations on itemized deductions and the phase-out of personal exemptions will simplify taxes for high-income taxpayers. These provisions are hidden taxes that serve no purpose that could not be generated by rate adjustments. In fact, the repeal was implemented in exchange for a smaller reduction in marginal tax rates for the highest income taxpayers than would otherwise occur. This trade-off-giving up explicit rate reductions in exchange for provisions that simplify the tax system-could provide a useful model for dealing with the problems created by the alternative minimum tax in the future.

Third, the reduction in income tax rates will indirectly help to simplify tax planning. Increasing the number of tax brackets does not generally make compliance more difficult; taxpayers will continue to look up their tax liability in a tax table. But lower tax rates simplify tax compliance indirectly by reducing the incentive to avoid taxes or find tax shelters.

Despite these changes, however, the overwhelming net effect of the bill will be to make tax filing and tax planning more complex.

  • Complexity due to increased uncertainty: Sunsets and phase-outs

    As noted above, the most novel feature of the bill is the sunsetting of all provisions as of December 31, 2010. In addition, various features of the bill phase-in and phase-out at different times. Taken at face value, these provisions make tax planning more complex, since the tax rules will be changing on a near constant basis, giving taxpayers incentives to shift the level, form and timing of their income and deductions. The good news is that few people take the sunset provisions at face value. The bad news, though, is that not taking them at face value makes tax planning even more complex, since it is not yet known what will replace the sunset and phase-out provisions, or when such provisions will be altered. The prevailing sentiment may be best summed up by Washington Post columnist Al Crenshaw (2001) who noted that “The new tax law doesn’t make planning unnecessary, it just makes it impossible.”

    While sunsets and phase-outs create planning difficulties for any situation, they appear to have particularly egregious effects in at least two areas: estate planning and pension choices. Taxpayers may end up having to make their wills and estate plans contingent on the year in which they die, because the provisions are legislated to change so massively on a year-to-year basis. For pensions, a key goal is to raise employer sponsorship of plans. But employers will naturally be reluctant to incur the fixed costs of creating new plans and educating their employees about the plan, if there is a chance that the plan, or the particular provisions that made the plan worth offering, may not be in existence after a few years.

  • Complexity due to increased number of choices

    Complex rules or documentation procedures are a common source of tax complexity. However, a new and increasing source of complexity might be termed “choice” complexity. This occurs when taxpayers are given numerous subsidies but may only use one or a few of them. This type of complexity has proliferated with regard to retirement saving, where taxpayers have been able to choose to allocate contributions among traditional, Roth, and education IRAs for several years. Under the tax bill, they will soon be able to choose to allocate 401(k) contributions between traditional and Roth plans as well. Similar issues apply to the variety of education subsidies that exist today, and which were expanded in EGTRRA.

    In economic models that feature fully informed consumers who make choices without incurring transactions costs, having more options is always preferable to having fewer options. However, in designing tax policy it is not necessarily the case that more options are always worth the added costs. First, the differences in benefits to a household between choosing one of a set of options versus another in the same set may be smaller than the costs of determining which the best option. But of course the household does not know that until it has undertaken the cost. Second, having more choices, for example with respect to retirement saving, requires more record-keeping by the taxpayer and the government.

  • Alternative minimum tax

    The AMT is a parallel tax system that was created to prevent high-income taxpayers from aggressively using tax shelters and deductions to eliminate their tax burdens. Taxpayers must calculate the AMT if their regular income tax liability is less than their AMT liability. The AMT is quite complex and requires tax filers to make many detailed calculations. Currently, fewer than 2 million taxpayers face the AMT.

    There are (at least) two “AMT problems” facing the tax code currently. The first is that, even without the new tax law, the number of taxpayers facing the AMT is scheduled to rise to about 20 million by 2011 (JCT 2001a). This occurs primarily because the AMT exemption amounts are not indexed for inflation. In addition, the overwhelming reason why these taxpayers will end up facing the AMT is that the personal exemptions and state tax deductions that they take in the regular income tax are not allowed in the AMT. Thus, the AMT will increasingly be capturing more people, and from the perspective of curtailing tax sheltering, the wrong people over time. While the new tax law does not make this problem worse, it does not do anything to fix it, either.

    The second problem is created by the new tax law. By 2010, when the law is fully phased in, JCT estimates that about 35 million taxpayers will face the AMT (JCT 2001a). This occurs because the tax law reduces regular income tax but not (in years after 2004) AMT.

    The bill offers only temporary, partial relief against the AMT, but that provision sunsets after four years. As a result, any gains in simplicity arising from lower income tax rates would be offset several times over after 2004 because lower rates would subject millions of taxpayers to the individual alternative minimum tax.

  • The estate tax

    Abolition of the estate tax sounds, on the surface, like a simplifying measure, but in the tax bill it is not. The bill stipulates three stages for estate taxes: from 2002 to 2009, the tax is modified in many ways. In 2010, the estate tax is abolished and step-up in asset value for inherited assets is repealed. In 2011, the estate tax is reinstated, as is the step-up in asset value for inherited assets.

    This creates several sources of complexity. The first is the sunset provision, as noted above. The second is the transition period before the estate tax is abolished. The estate tax phase-out is slow and involves several changes between now and 2009: the exemptions are raised, the tax rates are reduced, the credit for state taxes is abolished and replaced with a deduction, and gift tax limits are dramatically changed. Both the sunset and the transition make effective estate planning quite complex between 2002 and 2011.

    The third issue is the repeal of basis step-up at death. Under current law, when an heir receives an asset from an estate, the basis price is “stepped up” The new bill features “basis carryover:” heirs inherit an asset’s original basis price. Implementing carryover raises vexing issues. For example, some families would have to keep records for generations to keep track of asset purchase prices and improvements. Carryover basis would raise