# Presentation: 800341

## THE COSTS OF TAX COMPLEXITYPresentation to the President’s Advisory Panel on Federal Tax Reform

- Joel Slemrod
- March 3, 2005

## The Resource Cost of Collecting Taxes

The IRS budget: administrative costs.

The time and money spent by taxpayers and third parties: compliance costs.

The latter dwarfs the former, which is about $10 billion annually.

- The IRS budget: *administrative costs.*
- The time and money spent by taxpayers and third parties: *compliance costs.*
- The latter dwarfs the former, which is about $10 billion annually.

## How Big Are Compliance Costs?

-    Individuals: ***$85 billion.*** This includes the value
-       of 3.5 billion hours of time, the equivalent of
-       nearly two million hidden IRS employees—we
-       the taxpayers.
-    Businesses (other than sole proprietorships):
***      ******$40 billion***.
-    Total: ***$125 billion***.  This comes to nearly 13
-       cents per dollar of income tax receipts, and is
-       more than 12 times higher than the IRS
-       budget.  The cost ratio has probably, but not
-       certainly, grown in the last two decades.

## The Nature of Compliance Costs

-  Almost two-thirds of the cost is due to
-       recordkeeping.
-  Costs are highly concentrated.  Forty million
-        taxpayers spend five hours or less per year.
-  Compliance costs rise with taxpayers’ income and tax
-       liability, but less than proportionately: compliance costs
-       are regressive.
-  Costs are particularly high for self-employed
-        taxpayers.
-   Tax software reduces the difficulty of filling out
-        forms and doing calculations, but does not
-        reduce the burden of recordkeeping.

## Other Costs of Tax Complexity

- Complexity causes a capricious and often uncertain distribution of tax burdens.  Even professionals often disagree about the tax liability.
- It rewards those who have the means and inclination to find all the angles.
- It undermines trust in the fairness of the tax system, which may in turn undermine voluntary compliance.
- It reduces the transparency of the tax system.

## Why Is It So Complex?

- It reflects a belief that simpler, or less conscientiously enforced, systems cause an unfair distribution of the tax burden.
- The tax system is an awkward mixture of a revenue-raising system plus scores of incentive and reward programs.
- Income (and especially capital and corporate income) is often inherently difficult to measure, leading to inconsistencies that reward complicated transactions such as tax shelters and tax-oriented financial products.

## Evidence from Other Countries

- Only 6 countries in history have operated RSTs at rates of 10 percent or more; none do now.
- The cost-revenue ratio of European VATs ranges from 3 to 5 percent.
- The cost-revenue ratio for European income taxes is apparently not much higher than for their VATs, and is much lower than for the U.S. income tax; reliable comparable statistics are, however, scarce.

## What Are the Keys to Simplifying the Tax System?

- Resist fine-tuning the tax liability of individuals.
- Resist fine-tuning the economy by subsidizing and rewarding activities deemed to be especially valuable.
- Simplify sufficiently to take advantage of large-scale withholding by business, either radically as in a VAT or through a return-free income tax system.

## What Are the Tradeoffs to Be Faced in Simplifying the Tax System?

- Simpler business-based taxes like the VAT involve a massive redistribution of tax burden away from high-income to low-income families.
- Simplifying the tax base restricts activist government and requires settling for rough justice.
- Nothing simplifies the tax system without also affecting equity and efficiency.
- Transition to an even simpler new system will entail one-time costs as new rules are assimilated.

## Appendix:  Are There Simpler Alternatives? 

- The ***retail sales tax*** seems simpler, but at the revenue-neutral tax rate would not be administrable at our usual standard of equity and intrusiveness.
- A ***value added tax*** is administratively more robust, and could cut compliance costs significantly if it replaced the income tax.
- A true ***flat tax*** could cut compliance costs in half, but facilitates the reintroduction of complicating incentive and reward programs.

## Appendix Table 1 Details of Recent Estimates of the Collection Cost of the U.S. Income Tax System

|  | Slemrod (1996)1
TY1995 | IBM (2003)2
TY2000 | Slemrod (2004)3
TY2004 |
| --- | --- | --- | --- |
| Individuals |  |  |  |
| Hours (bil.) | 2.8 | 3.21 | 3.5 |
| Average value per hour ($) | 15.0 | 20.0 | 20.0 |
| Value of hours ($ bil.) | 42.0 | 64.2 | 70.0 |
|      Expenditures ($ bil.) | 8.0 | 18.8 | 15.0 |
| Total resource cost ($ bil.) | 50.0 | 83.0 | 85.0 |
|  |  |  |  |
| All businesses, other than sole proprietorships |  |  |  |
| Hours (bil.) | 0.8 |  |  |
| Average value per hour ($) | 25.0 |  |  |
| Total resource cost ($ bil.) | 20.0 |  | 40.0 |
| (continued on next slide) |  |  |  |

## Appendix Table 1 (continued)Details of Recent Estimates of the Collection Cost of the U.S. Income Tax System

|  | Slemrod (1996)1
TY1995 | IBM (2003)2
TY2000 | Slemrod(2004)3
TY2004 |
| --- | --- | --- | --- |
| Total compliance cost ($ bil.) | 70.0 |  | 125.0 |
| Total administrative cost ($ bil.) | 5.0 |  | 10.0 |
|  |  |  |  |
| Total collection cost ($ bil.) | 75.0 |  | 135.0 |
|  |  |  |  |
| Ind. income tax receipts ($ bil.) | 590.2 | 1004.5 | 809.0 |
| Corp. income tax receipts ($ bil.) | 157.0 | 207.3 | 189.4 |
| Total income tax receipts ($ bil.) | 747.2 | 1211.8 | 998.4 |
|  |  |  |  |
| Total collection cost as a % of total income tax receipts | 10.0 |  | 13.5 |

## Appendix Table 1 (continued)Details of Recent Estimates of the Collection Cost of the U.S. Income Tax System

- 	Notes to table:  All dollar figures are in current dollars.  The tax receipts figures refer to fiscal years, and are taken from *Economic Indicators*, December 2004 (U.S. Government Printing Office, Washington, D.C.).
- 	1 Slemrod (1996) refers to detailed estimates discussed in my article entitled “Which Is the Simplest Tax System of Then All?” published in H. Aaron and W. Gale (eds.), *The Economics of Fundamental Tax Reform*, The Brookings Institution, 1996, pp. 355-91.
- 	2 IBM (2003) refers to the IBM Business Consulting Services contract work with the IRS, discussed in Guyton, John L., John F. O’Hare, Michael P. Stavrianos, and Eric Toder, “Estimating the Compliance Cost of the U.S. Individual Income Tax,” *National Tax Journal* (September, 2003), pp. 673-88.
- 	3 Slemrod (2004) refers to written testimony submitted to the Committee on Ways and Means, Subcommittee on Oversight, Hearing on Tax Simplification, Washington, D.C., June 15, 2004. Only the tax receipts numbers have been updated from that testimony.