Posted on Jul 21, 2011
What Tax Reform Should Really be Focused On
Discussions of tax reform today often include the need to reduce the deficit. However, if tax reform is focused solely on that purpose, we are unlikely to see real change. Tax reform should address structural and operational weaknesses in the tax system and ensure that the system supports rather than works against our economic and societal goals.
This is not to say that deficit reform won't include tax changes -- it likely will. Efforts to reduce the deficit and debt will likely involve tax rate changes and perhaps reduction or elimination of some deductions and credits. I'll address that in a future post on tax reform and spending, a lot of which is buried in the tax law.
So, why should our federal tax system be reformed? Well, it does not do well in meeting principles of good tax policy. Also, it should be updated to reflect 21st century ways of living and doing business. Here are a few examples.
First, the federal income tax system has grown far too complex. It violates the principle of simplicity. The IRS National Taxpayer Advocate (NTA) has often reported to Congress that the most serious problem facing taxpayers is the “confounding complexity of the tax code." About 60% of individuals hire someone to prepare their return and 29% purchase tax prep software (NTA, page 5). The instructions on how to prepare the simplest form – Form 1040EZ, are 40 pages long.
This complexity is also costly. Per the NTA, taxpayers spend over 6 billion hours each year complying with their federal tax obligations. The NTA's annual report to Congress for 2010 noted, "If tax compliance were an industry, it would be one of the largest in the United States. To consume 6.1 billion hours, the “tax industry” requires the equivalent of more than 3 million full-time workers." Wow!
Our federal system has inefficiencies that leads to a lack of collection of owed taxes. This gap – referred to as the "tax gap," is an astouding $345 billion per year. Also, in addition to high compliance costs, special rules spread throughout the tax law affect decision-making and alter the effective tax rates on different activities and investments. For example, several favorable tax rules for home ownership result in a zero effective tax rate on such investments. In contrast, the effective tax rate on corporate investment is about 26%.
Differences between US tax rules and those in other countries can also affect international competitiveness. In 2006, the director of Intel told the House Ways & Means Committee, “A critical issue we must now consider when deciding where to locate a new wafer fabrication plant is that it costs $1 billion more to build, equip, and operate a factory in the U.S. than it does outside the U.S.” The savings are due to government grants and tax breaks.
Today, the U.S. combined federal and state income tax rate is highest among industrialized countries. Also, over 120 countries use a VAT which is border adjustable (imposed on imports, but not on exports), but the U.S. does not. Also, many countries only tax income earned within their borders while the U.S. continues to use a worldwide tax base.
Finally, there are inequities in our federal tax system. Deductions are worth more to higher income individuals. Employees with employer-provided health insurance reap a greater tax benefit than other individuals. Some deductions, such as for interest on a vacation home, make no sense, and result in a lower tax bill for those with greater economic means.
The tax system could also be modernized, such as by reforming how it applies to international transactions, which are far more prevalent today than when the tax law was created. Also, technology could be better used to streamline the tax filing process.
Tax reform efforts should use principles of good tax policy to identify weaknesses and possible solutions. This is a fairly objective approach that could help steer away from the often bi-partisan debates that focus on who is getting or keeping tax cuts.
In a future post, I'll address how spending reforms that are part of deficit reform must also consider the spending in the tax law. I'll explain that concept and how it contributes to our $1 trillion deficit. I will also respond to any comments posted, so I hope you'll leave some comments or questions.
For more on reasons for federal tax reform, please check this out.
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Annette Nellen has been running the 21st Century Taxation website and blog for over four years. Her focus is raising awareness on tax system weaknesses, possible solutions and the need to modernize tax systems and follow principles of good tax policy. She is a full-time professor in a graduate tax program (MST) at San Jose State University and an active member of the tax sections of the AICPA, ABA and California Bar. Annette has been actively involved in studying tax policy and reform for over 20 years – check out her website for more information.
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