Prelude to simplification: why taxes are so complex.

PRELUDE TO SIMPLIFICATION: WHY TAXES ARE SO COMPLEX

Complexity is built into the tax legislation process.

Tax complexity results from a tax legislative process that's driven by lobbyists, campaign fundraisers, budget watchers, legislators working in the "sunshine" and proponents of tax expenditures. This creates a tremendous institutional bias toward complexity. Unfortunately, simplication is everyone's third or fourth priority.

To change this bias, the American Institute of CPAs has launched a campaign for tax simplification. This article details how such a complex tax law has come about, why vested interests increase complexity and what can be done to encourage simplification of the law.

WHAT'S WRONG WITH COMPLEXITY

The U.S. tax system is founded on voluntary compliance. Complexity erodes this foundation and reduces revenues. Ultimately, when tax laws are difficult to understand and comply with, taxpayers lose respect for the system itself.

Complexity requires hours of expensive professional talent and mountains of paperwork. In the past, a good tax adviser could help arrange a client's affairs to minimize the client's tax burden. Today, a tax adviser ignorant of complexity can prepare an incorrect tax return showing a lower tax than the same return prepared by a competent preparer. And the low odds of being audited make this a successful strategy!

Simplification is possible. Given today's deficit-ridden government, any simplification proposals must be "revenue neutral"--that is, they must not reduce the government's revenue. This means simplification will happen only when taxpayers go against their basic instincts and agree to changes that may result in higher taxes.

The first step is to develop a vocal constituency for tax simplification. The second step is to reform the tax legislative process. Few simplification proposals will become law and stay simple without changes in the tax legislative process.

TAX EXPENDITURES

Tax provisions can be classified as "structural" or "tax expenditures."

* Structural provisions are those necessary to implement a tax on net income. Often, the underlying transactions are extraordinarily complex and require a complex tax law. However, a complex tax law can still be logical and coherently structured. In this case, simplification means controlling complexity.

* Tax expenditures are tax subsidies of financial incentives that benefit a particular group of taxpayers. They constitute the single biggest cause of complexity in our income tax system and they're not needed to implement a tax on net income. Tax expenditures with broad constituencies include home mortgage interest, charitable deductions, individual retirement accounts, personal and dependent exemptions, the standard deduction and childcare credit. Narrower--but powerful--constituencies support accelerated depreciation, low-income housing credits, statutory oil and gas depletion allowances, parsonage exclusion and handicapped access deductions.

A tax expenditure isn't inherently wrong, provided a complete cost-benefit analysis determines it's the most efficient method for a necessary government intervention in the economy. However, no such analysis currently is performed; and that results in many inefficient tax expenditures being passed.

Unlike spending programs, tax expenditures are immune from the automatic cuts of the Gramm-Rudman Act. Consequently, there's a built-in bias toward creating tax expenditures.

* Non-tax-writing congressional committees can further their missions (for example, ensuring better housing or employment) by proposing or supporting tax expenditures. And representatives gain the votes of those affected by the programs.

* Government agencies looking to add programs outside their limited budgets will favor a tax expenditure--any tax expenditure--to fund the programs.

THE BUDGET PROCESS

The budget process itself contributes heavily to tax complexity. The Congressional Budget and Impoundment Control Act of 1974 requires Congress to specify annually the amount by which taxes or spending (or both) must be changed to meet budgetary targets. This means additional revenue--a tax increase--is needed each year to fund essential programs.

Because of the current threat of a presidential veto, taxes can't be raised explicitly. This forces lawmakers to resort to such tactics as "base broadeners," stricter compliance and user fees--in other words, closed loopholes, fewer tax expenditures, more information reporting, faster tax collection and higher penalties. These are called "cats and dogs" and they raise little revenue when considered singly but in the aggregate they raise a lot. Finding dozens of highly targeted cats and dogs, however, takes time that could be spent considering simpler alternatives.

Every proposal for a new expenditure must be accompanied by a proposed method of financing. But a tax law grafted onto a spending bill invariably results in complexity (for example, the recent catastrophic Medicare bill, which was subsequently repealed). In order to appear revenue neutral, tax proposals require narrow provisions; the result is a tax increase that's complex but politically acceptable.

Furthermore, every tax proposal must be accompanied by a projected revenue gain or loss. Because of the budget deficit, policy decisions sometimes are based more on the amount of expected revenue than on coherent tax policy.

The secret art of revenue estimating starts with Internal Revenue Service income statistics from prior years. These are "massaged" with Census Bureau and other statistical data. To avoid arguments over their veracity, the assumptions--and guesswork behind the estimates--rarely are disclosed. After the Tax Reform Act of 1986 required taxpayers to enter a Social Security number for each dependent age five or older, 7.5 million dependents disappeared--a completely unexpected drop. A provision that had been considered a small revenue raiser in the TRA turned out to be one of the biggest--worth about $3 billion per year.

GOVERNMENT IN THE SUNSHINE

Before the "good government" or "sunshine" reforms of the 1970s, the House Ways and Means Committee consisted of 25 members; the chairman was chosen by seniority. To minimize turnover and encourage integrity, committee members chose new members with "safe seats." Tax legislation was written in executive session, away from the scrutiny of lobbyists. There was no public record of committee members' positions during the closed sessions.

Today, the Ways and Means Committee has 36 members--23 Democrats and 13 Republicans. The chairman is selected by secret ballot, which makes him subject to removal. Committee assignments are made by the majority Steering and Policy Committee (Democratic) and members in less safe seats are routinely assigned to Ways and Means. This gives them less freedom to vote their consciences. Moreover, proceedings are open to the public, which floods committee rooms with lobbyists.

Sunshine reformers theorized that when the political process was opened to public scrutiny (particularly the public interest lobbies), the exposure would curtail special interest abuses of the tax code. This theory made several assumptions:

* The public cares about the narrow tax benefits of others.

* It cares enough to follow complicated and tedious congressional proceedings.

* Public displeasure will convince lawmakers to vote accordingly.

Instead, opening up the system simply increased the demand for wider benefits to special interests. Congress now finds it must defeat the intent of sunshine in order to pass tax legislation. Chairman Bob Dole (R-Kans.) excluded some Democratic members of the Senate Finance Committee from meetings when discussing the Tax Equity and Fiscal Responsibility Act of 1982. And the final bill was hammered out by a conference committee in executive session.

In the TRA deliberations, Senate Finance Committee Chairman Bob Packwood (R-Ore.) explained the need to shield legislators from lobbyists, the press and the public: "When we're in the sunshine, as soon as we vote, every trade association in the country sends out its mailgrams and makes phone calls in 12 hours and complains about the members' votes. But when we're in the back room, the senators can vote their consciences. They vote for what they think is good for the country. Then they can go out to the lobbyists and say, |God, I fought for you. I did everything I could. But Packwood just wouldn't give in.'"

TAX LOBBYISTS

Tax lobbyists, too, contribute to complexity: and there's an army of them--many of whom are former members of Congress or the administration. Many call government tax policy officials on a first-name basis and seek legislative solutions to clients' problems. A lobbyist often is convinced a statute is defective or that fair and proper tax treatment requires an Internal Revenue Code amendment.

While government tax policy officials find it useful to learn about inequities in the IRC or proposed legislation, this information is presented by persons with influence and bias, rather than by those representing an independent, theoretical perspective. The lobbyist probably will not consider the effects of his efforts on the U.S. tax system as a whole.

Lobbyists meet any simplication efforts, which curtail their clients' particular tax subsidies, with well-financed campaigns portraying social or economic upheaval. Moreover, lobbyists hail each new tax expenditure as the solution to the country's problems.

CAMPAIGN FUNDRAISING

The ability to legislate tax laws is accompanied by the ability to raise campaign contributions. Congressmen can exact contributions simply by threatening harmful laws, without any intention of enacting them. Called "milker bills," they're designed to milk payments from potentially affected taxpayers. For example, Representative Sam, in need of campaign contributions, has a bill introduced that excites a constituency to urge Sam to work hard for its defeat (easily achieved); when he seems to have accomplished this goal, the group pours funds into his campaign coffers and Sam is endeared to his constituency for his effectiveness.

Today, there are 4,268 political action committees, up from 113 in 1972. PAC contributions are limited to $10,000 per congressional candidate for a primary and general election combined. But there are ways around this. Fortunately, it's unlikely a lawmaker opposed to a financial supporter's viewpoint will change his position because of a contribution. But an undecided lawmaker may vote for his contributor's viewpoint--especially if there's no strong opposition from his constituents.

Why else would donations per two-year election cycle to Ways and Means members have increased from $4.4 million in 1977-78 to $17.7 million in 1985-86? Committee members averaged $455,000 each during 1987-88, $74,000 more than other congressmen. The chairman of the Senate Finance Committee raised $3.8 million during the first six months of 1987--three times more than any other senator up for reelection.

The TRA illustrates how Congress balances the interests of constituents and contributors, adding to the complexity of the tax law. The act repealed investment credit and capital gains and imposed passive activity rules--all major blows to broad-based special interests. At the same time, it created new tax expenditures such as real estate mortgage investment conduits and private activity bonds. The standard special exclusion clause in the 1986 TRA reads, "This section shall not apply to a corporation incorporated on [date], which has its principal place of business in [city, state]" and there are hundreds of other special clauses. The TRA is 1,900 pages long and contains 1,850 separate IRC amendments--the most complex single tax act ever enacted.

ACHIEVING SIMPLIFICATION

The AICPA tax simplification subcommittee considers simplification to be the ability of taxpayers and their advisers to understand and comply with the tax laws that pertain to them and the ability of the IRS to administer such laws. There's no simple program for achieving tax simplification.

Except for the recordkeeping burden, members of the general public are shielded from most tax complexity. When they encounter a complex tax situation, they hire an adviser. Thus, tax complexity means

* "How much does it cost to prepare my return?"

* "How much tax do I owe?"

It's therefore unlikely the general public will support simplification vocally--especially if it means simple new taxes. At best, it will understand the issue and not oppose simplification.

There have been several calls for the creation of a "code convention" to sift through the IRC, provision by provision, to find a simpler or more direct way of achieving the implicit goals of each. For example, in 1970 Congressman George Bush endorsed and entered into the Congressional Record a detailed proposal to set up a committee for simplification of federal taxation. The AICPA-American Bar Association Invitational Conference on Reduction of Income Tax Complexity heard a suggestion for the appointment of a "director of simplification" in a Treasury undersecretary position.

But the forces that pervade the tax-writing process--lobbyists, campaign fundraisers and sunshine government--will strongly oppose any reform that would diminish or usurp their influence. Consequently, the recommendations of a code convention or director of simplification would face stiff, organized opposition.

BUILDING A CONSTITUENCY

A vocal constituency can be developed best from among the tax professionals who must deal with complexity daily. CPAs can explain that tax simplification simply will mean raising revenues that would have been raised anyway--but raising them with greater efficiency.

The IRS supports and devotes substantial resources to tax simplification and is sponsoring a major project to simplify tax regulations. The IRS schedules an annual research conference, maintains a Commissioner's Advisory Group of outside advisers and is quick to assist independent groups with simplification projects.

Most former congressional and Treasury tax staffs are willing to support simplification. The current staffs have announced their willingness to work on simplification projects--if their superiors make it a high priority.

Any campaign for tax simplification must enlist congressional support and there are members of Congress who would champion such an effort. However, only if a constituency cries out for simplification will Congress make it a priority.

HOW CPAs CAN HELP

The AICPA has issued an open letter on tax simplication (see exhibit 1 at left). Practitioners can help in three ways:

1. Reproduce the letter, sign it and send it to your representatives in Congress.

2. Send the AICPA tax division copies of your letters. We'll use them in our efforts to convince Congress there's a constituency for tax simplification.

3. Join the AICPA federal taxation division and volunteer to work on a subcommittee. Tax simplification projects rely heavily on the expertise of the technical subcommittees.

If a tax simplification constituency can be organized, Congress can be expected to respond willingly and favorably. If not simplified, the tax system that forms such a strong foundation for our free government is in danger of collapsing. Simplification must become a top priority.

                EXHIBIT 1
                AICPA

Open letter on tax simplification

To the President and the Congress:

We believe that * Voluntary compliance is the foundation of the U.S. tax system. * The tax law is difficult to understand and comply with because of its complexity. * Complexity greatly increases the cost of compliance. * Complexity reduces respect for the tax system; this reduces voluntary compliance and revenues. * Complexity results in reduced levels of enforceability by the Internal Revenue Service, which in turn reduces voluntary compliance and revenues. * Complexity in the tax law is, at least in part, the result of a legislative process that promotes complexity and disregards simplification. We, therefore, call for the Congress and the president to simplify the U.S. tax law. As a first step toward that end, we call for the creation of a commission on the tax legislative process. The primary purpose of the commission would be to recommend to the Congress and the president ways to change the legislative process that would promote the simplification of the tax law.

PHOTO : The AICPA "simplify" buttons are very popular at the Internal Revenue Service and the Department of Treasury. Will Congress be next?

JAY STARKMAN, CPA, is a sole practitioner in Atlanta, Georgia. He is chairman of the American Institute of CPAs tax simplification and efficiency subcommittee and served on the steering committee of the AICPA/American Bar Association Invitational Conference on Reduction of Income Tax Complexity held in Washington last January. The information in this article is based partly on papers presented at that conference.