# Presentation: 431493

## Return-Free Tax Systems and Taxpayer Compliance Costs

- Presentation to the President’s Advisory Panel on Federal Tax Reform
- by Eric J. Toder
- Urban Institute and Tax Policy Center
- May 17, 2005

## Issues in Return-Free Systems

- What are Return-Free Systems?
- What is the Problem They Seek to Correct?
- What is the Private-Sector Response?
- Who Can Benefit from Return-Free Systems?
- What Tax System Changes are Needed to Make Them Work?
- Are They a Substitute for Tax Simplification?

## Types of Return-Free Systems

- Exact Withholding
- Many taxpayers do not have to file returns; correct tax liability is pre-paid by withholding
- Examples:  United Kingdom, Germany, Japan
- Tax Agency Reconciliation
- Tax agency computes final tax liability based on 3rd party data (e.g., W-2s, Form 1099s)
- Examples in U.S. – Michigan, California test

## The Problem:  Compliance Costs

- IRS Estimates 26 hours and $157 per return in 2002
- But costs are disproportionately borne by those with more complex returns
- Self-employed taxpayers
- Form 1040 filers

## Chart 1

- Source:  IRS Individual Tax Burden Model

- Source: IRS Individual Taxpayer Burden Model

## Chart 2

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- Source:  IRS Individual Income Tax Burden Model

## The Response: Computerization

- Tax Preparation Methods Changing
- More paid preparer use
- Dramatic growth in software
- Over 85% of returns prepared on computers
- Growth in electronic filing
- New methods reduce only some costs
- Taxpayers still incur large costs of record-keeping, gathering materials and tax planning

## Chart 3

- Source:  IRS Taxpayer Usage Study

## Chart 4

- Source:  IRS Taxpayer Usage Study

## Potential Users of Return-Free Systems: Exact Withholding

- In lowest tax bracket, wage income only, no itemized deductions, no credits except child credit
- 17% of taxpayers in 1999 (U.S. Treasury)
- Extra 10% bracket added in 2001
- Administrative changes could raise use to 38%
- Withholding on other income sources (interest, dividends, pensions and IRAs, unemployment benefits, capital gains distributions by mutual funds)
- Separate determination of EITC eligibility for non-filers

## Features of UK Law that Facilitate Exact Withholding

- Individual filing
- Only 3 rates; 80% pay basic tax rate
- Withholding on interest and dividends
- Exemption of first £7,200 of capital gains and of gains on housing
- Fewer credits and deductions
- No medical deduction (national health)
- Charities file for charitable deduction
- Mortgage benefit paid through lenders

## Potential Users:  Tax Agency Reconciliation

- People whose income and deductions all come from sources reported by third parties
- Everyone who can use exact withholding, plus:
- Two earner couples
- People with matched sources of income and deductions (interest, dividends, mortgage interest etc.)
- About 50% of taxpayers eligible (GAO and IRS), but estimates of participation rates vary
- Examples of ineligible taxpayers:
- Taxpayers with self-employment income, capital gains, certain itemized deductions and credits

## How Tax Agency Reconciliation Works

- IRS sends notices to taxpayers
- Based on IRS notice, taxpayers must:
- Determine eligibility and elect to participate
- Report filing status and number of dependents
- IRS computes tax with data from employers, taxpayers, and financial institutions
- Taxpayers can contest IRS assessment
- Refunds or tax payments are made

## Some Pros and Cons

- Exact withholding would require major tax simplification and administrative changes
- Tax agency reconciliation more feasible, but involves additional costs
- Accelerated processing of information returns
- Delays in refunds
- Compliance costs would be reduced for some, including psychic costs of return filing

## Other Considerations

- Taxpayers’ trust in IRS calculations
- Taxpayers’ continuing responsibility to supply complete and accurate information
- Cost-effective use of IRS budget resources
- Competition with private sector preparers and software
- More spending on enforcement higher priority
- Should people be responsible for own tax returns?
- Responsibility of citizenship
- Awareness of cost of government
- Transparency of tax burdens

## Effects of Tax Simplification

- Would facilitate having more taxpayers subject to a return-free system
- Exact withholding would remain limited if we retain joint filing
- Simplification would reduce potential gains from a return-free system
- Simplification would not relieve self-employed and small businesses of need to file returns

## Conclusions

- Return-free systems work only for relatively simple returns with low compliance costs
- Tax agency reconciliation more practical for U.S. than exact withholding
- It is not clear that benefits of return-free system exceed costs, given widespread use of preparers and software
- Return-free systems are not a substitute for tax simplification