Hey Candidates, Analyze This!

Spin in politics is inevitable, but Gore and Bush could cut through the clutter by establishing a basic principle: Just how much is government's rightful claim on the nation's economy? The total tax burden is the highest it's ever been--and understanding the tax code is near impossible. Is this the direction we should be taking?

When Justice Oliver Wendell Holmes, Jr. made his now famous comment, "Taxes are what we pay for civilized society," the year was 1904 and Americans were paying an average of $15 total in taxes. Of course, that was almost a century ago. But even in today's dollars, that amounts to only $251 per capita--a relatively low price to pay for a civilized society.

Whether we feel society is more or less civilized today, the price has certainly seen a hike over the last century. During the past 96 years, taxes have grown 30-fold to $10,447 per person. Federal taxes make up 68 percent of the total ($7,238), and state and local taxes make up the remaining 32 percent ($3,210). See Figure 1.

True, none of these facts would be an issue today if income had risen just as rapidly as taxes. But, as Figure 2 shows (utilizing data published every April by the Tax Foundation), charting the 20th century's tax burden as a percentage of income yields a trend line that is startling, if not quite as steep.

These trends are a concern to any business trying to capture a fraction of the American consumer's disposable income. Comparing the per capita tax burden to expenditures on goods and services shows that Americans are spending more money per capita in 2000 on taxes ($10,447) than on food ($2,713), clothing ($1,436), and shelter ($5,913) combined (see Figure 3). In fact, Americans are spending more on federal taxes alone than on any of the other major budget items.

The Complexity Surtax 

Every system of taxation requires some effort on the part of taxpayers. But if the process of filing tax returns becomes so complex that the average person can't complete it correctly without hiring professional help--and even professionals have difficulty--then the cost of compliance becomes a "surtax" levied in addition to the taxes themselves.

One measure of the individual tax code's complexity is the declining percentage of taxpayers who feel confident enough to fill out their own returns. That percentage has now dipped below half; the rest are professionally prepared. At the lower end of the income scale, filing a return that takes advantage of the Earned Income Credit is so difficult, and profitable, that tax preparers who advertise advance payment of refunds are proliferating. A blizzard of dependent- and education-related credits crowd the middle-income returns, and on the high end, as many as 8.8 million households may soon find themselves subject to the alternative minimum tax (AMT), says Congress' Joint Committee on Taxation.

Another highly complex area of the code is the estate tax, the repeal of which is one of the most conspicuous tax issues dividing the presidential candidates. The high rates and massive complexity of the estate tax create a substantial incentive for talented, wealthy business leaders to discontinue or slow their working, earning, and job-creating activities well before they would if the estate tax were repealed. Tax Foundation research has shown that for the hardest-hit taxpayers, the estate tax has the same impact as would a doubling of the top income tax rate.

As complicated as individual taxes may seem, individual tax compliance was actually eased substantially by the Tax Reform Act of 1986, and is much simpler than the business side of the tax code where simplification has been a byword since the earliest days of the income tax. Indeed, the 1927 Report of the Joint Committee on Internal Revenue Taxation declared succinctly: "It must be recognized that while a degree of simplification is possible, a simple income tax for complex business is not."

The Causes of Complexity

Economic and political forces create the complexity that bedevils our tax law. From an economic point of view, tax law complexity is almost wholly related to tax base questions--that is, questions or uncertainties about the timing or definition of taxable transactions. The inherent complexity of an income tax resides in the difficulty of defining income and determining when to recognize income and expense for tax purposes. Over time, the political process of give and take has made these difficult tax base questions inordinately complex. The definition of taxable income has not only expanded dramatically, but has undergone chronic change.

The income tax was placed at the core of the federal tax system by the Internal Revenue Act of 1954. Since then, the income tax has grown from about 41 percent of the entire tax code to more than 60 percent, and the volume of income tax regulations has grown even higher. The number of words in the code, for example, has had a steep and steady growth trend, and the subsections of some of the code's major subchapters have multiplied rapidly (see Figure 4).

The complexity generated by the growth and constant change of the tax code creates two general types of economic costs. One is the overhead cost associated with the economically sterile exercise of tax planning, compliance, and litigation, all of which essentially act as a tax surcharge on taxpayers. The second cost results from the economic opportunities that are foregone because of taxpayer uncertainty.

If taxpayers cannot accurately predict the tax consequences of a business plan or investment, whether because of vagueness, complexity, or instability in the tax code, then tax policy is handicapping the growth and dynamism of the U.S. economy. This is particularly true in businesses for which research and development require longer and longer lead times.

Veteran tax professionals in large firms consistently identify depreciation as the most complex and counterproductive provision of the code. The corporate AMT's complexity is always mentioned as well. One problem is that depreciation schedules cause after-tax returns to vary substantially from industry to industry, distorting the allocation of capital. Since its passage in 1986, the corporate AMT has required firms to track all their financial operations in an additional and entirely separate way, effectively doubling their tax compliance record keeping.

However, despite all the gyrations required of large firms who face international rules, foreign tax credit issues, and transfer pricing problems--just to name a few more areas of complexity--small firms actually suffer disproportionately. Because of economies of scale in tax compliance, "complexity surtax" is a much greater percentage of small firms' income. Ironically, all of their compliance effort is essentially for naught, at least from a public finance point of view, because the top 1 percent of firms in asset size pay well over three-quarters of the corporate income tax take. Clearly, this disproportionate effort by small firms yields a poor cost-benefit ratio from a public policy perspective.

Mitigating the Burden of Taxes

If the high cost of complying with the federal income tax were a necessary price to pay for a fair and effective tax system, perhaps there would be little room for complaint. But the complexity and its costs are clearly excessive. So what can be done to reverse the trend? Short of overhauling the entire federal tax system, Congress can work two ways to reduce the complexity of the current tax system and its attendant compliance costs. First, Congress should strive for code stability. The taxpayer uncertainty that results from frequent tax law changes is a key source of complexity. Second, tax writers and regulators should place a higher premium on tax simplicity. There is an inherent trade-off between completeness and simplicity, and despite the surplus, tax writers and regulators have continued their deficit-era pursuit of tax revenue, trying to shut off all avenues of tax avoidance without regard to the incremental costs or unintended consequences of such an approach to governance.

These incremental efforts require constant resistance to the demands of powerful forces. Another route to simplification is an all-out push for fundamental reform. Several plans, such as Rep. Dick Armey's (R-TX) flat tax plan, boast dramatic simplification as a key benefit, Another recent addition, the Simplified USA Tax proposed by Rep. Phil English (R-PA) would greatly simplify business taxation and make our businesses competitive with those of foreign nations.

In general, these plans seek to reform the tax system by moving to cash flow as the tax base, rather than accrued income. A cash-flow tax, as it applies to business, totals up business receipts and then subtracts purchases from other businesses. On the individual level, the approach resembles a universal IRA. It eliminates the double tax on saving and eliminates any tax consequences of shuffling the composition of a savings portfolio.

Misguided political tampering can ruin the integrity of any system, but we must not stop agitating for a simpler tax code with reasonable rates that raise the income the government needs--no more and no less. The stakes for our economy are too high to pursue any other course.

Scott Hodge is executive director of the Tax Foundation, a nonpartisan, nonprofit organization that has monitored fiscal policy at the federal, state, and local levels since 1937.