a

GAO

United States Government Accountability Office

Report to Congressional Requesters

August 2005 TAX POLICY

Summary of Estimates 

of the Costs of the 

Federal Tax System

GAO-05-878
What GAO Found

United States Government Accountability Office

Why GAO Did This Study

Highlights

Accountability Integrity Reliability

www.gao.gov/cgi-bin/getrpt?GAO-05-878.

To view the full product, including the scope 

and methodology, click on the link above. 

For more information, contact James White at 

(202) 512-5594 or whitej@gao.gov. 

Highlights of GAO-05-878, a report to 

House Majority Leader Thomas DeLay, 

and the Honorable John Linder, House of 

Representatives 

August 2005

TAX POLICY

Summary of Estimates of the Costs of the 

Federal Tax System 

Complying with the federal tax system costs taxpayers time and money. 

Estimating total compliance costs is difficult because neither the 

government nor taxpayers maintain regular accounts of these costs and 

federal tax requirements often overlap with recordkeeping and reporting 

that taxpayers do for other purposes. Although available estimates are 

uncertain, taken together, they suggest that total compliance costs are large. 

For example, combining the lowest available estimates for the personal and 

corporate income tax yields a total of $107 billion (roughly 1 percent of 

GDP) per year. As noted, whether this is a definitive lower bound for 

compliance costs is uncertain. 

The tax system also results in economic efficiency costs because tax rules 

cause individuals to change their behavior in ways that ultimately leave them 

with lower-valued combinations of consumption and leisure than they would 

have obtained if the tax system did not affect their behavior. Estimating 

efficiency costs is very challenging because the tax system has such 

extensive and diverse effects on behavior. In fact, we found no 

comprehensive estimates of the efficiency costs of the current federal tax 

system. The two most comprehensive studies we found suggest that these 

costs are large—on the order of magnitude of 2 to 5 percent of GDP each 

year (as of the mid-1990s). However, the actual efficiency costs of the 

current tax system may not fall within this range because of uncertainty 

surrounding taxpayers’ behavioral responses, changes in the tax code and 

the economy since the mid-1990s, and the fact that the two studies did not 

cover the full scope of efficiency costs. 

The goal of tax policy is not to eliminate compliance and efficiency costs. 

The goal of tax policy is to design a tax system that produces the desired 

amount of revenue and balances the minimization of these costs with other 

objectives, such as equity, transparency, and administrability. In addition, 

whether compliance and efficiency costs could be reduced by redesigning 

the tax system and, if so, by how much would depend critically upon the 

detailed characteristics of the new tax system. 

Components of the Total Cost of a Tax to Taxpayers 

In 2005, Americans will pay about 

$2.1 trillion in combined federal 

taxes, including income, payroll, 

and excise taxes, or about 16.8 

percent of Gross Domestic Product 

(GDP). However, the amount of 

taxes paid does not reflect the total 

cost to taxpayers of the federal tax 

system. In addition to taxes paid, 

taxpayers also bear compliance 

costs and efficiency costs. 

Understanding the magnitude of 

these additional costs is important 

because every dollar spent on 

compliance and lost due to 

inefficiency represents a dollar that 

society could have spent for other 

purposes. 

In response to a congressional 

request for information on the 

magnitude of the compliance and 

efficiency costs of the current 

federal tax system, this study 

describes the nature of these costs, 

presents the difficulties associated 

with estimating them, and 

summarizes existing estimates of 

their magnitude. GAO did not 

make independent estimates of 

compliance or efficiency costs nor 

did we replicate any of the studies. 

GAO is not making any 

recommendations in this report. 
Page i GAO-05-878 Tax Policy

Contents

Letter 1

Results in Brief 3

Background 4

Estimates of Tax Compliance Costs Are Uncertain Because 

Taxpayers Generally Do Not Record Them; However, Total Costs 

Are Likely to Be Large 6

Efficiency Costs Arising from Tax-Induced Changes in Behavior Are 

Likely to Be Large but Can Only Be Modeled with Considerable 

Uncertainty 16

Agency Comments and Our Evaluation 25

Bibliography 26

Tables Table 1: Features of the Tax System as of July 2005 4

Table 2: Available Estimates of Tax Compliance Costs for 

Individual Taxpayers (Including Self-employed) 13

Table 3: Available Estimates of Tax Compliance Costs for 

Corporations and Partnerships 14

Table 4: Estimates of the Efficiency Gains from the Removal of 

Selected Distortions in the Current Tax System 20

Figures Figure 1: Components of the Total Cost of a Tax to Taxpayers 6

Figure 2: Compliance Burden Is One Cost Taxpayers Face in 

Complying with the Tax System 7

Figure 3: Efficiency Costs Are One Cost Taxpayers Face in 

Complying with the Tax System 17

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Page 1 GAO-05-878 Tax Policy

United States Government Accountability Office

Washington, D.C. 20548

A

August 26, 2005 Letr

The Honorable Thomas DeLay

Majority Leader 

House of Representatives

The Honorable John Linder

House of Representatives

In 2005, Americans will pay about $2.1 trillion in combined federal taxes, 

including income, payroll, and excise taxes, or about 16.8 percent of Gross 

Domestic Product (GDP). These taxes fund the services provided by 

government. As taxpayers, we balance the costs of taxes with the benefits 

of government.

However, the amount of tax revenue collected does not reflect the total 

cost to taxpayers of the federal tax system. In addition to taxes paid, 

taxpayers also bear compliance costs and efficiency costs. Compliance 

costs include the value of the taxpayer’s time and resources, along with any 

out-of-pocket costs to paid tax preparers and other tax advisors, spent to 

ensure compliance with the tax laws. Efficiency costs result when taxes 

alter the economic decisions that people make—decisions such as how 

much to work, how much to save, what to consume, and where to invest—

in ways that reduce overall well-being. Understanding the magnitude of 

these additional costs is important, because every dollar spent on 

compliance and lost due to inefficiency represents a dollar that society 

could have spent for other purposes. Moreover, these costs could change if 

policymakers decide that the projected imbalances between federal 

revenues and expenditures can only be addressed by changes to both sides 

of the fiscal system.

Despite the existence of these costs and their size, the goal of tax policy is 

not to eliminate compliance and efficiency costs. The goal of tax policy is 

to design a tax system that produces the desired amount of revenue and 

balances the minimization of compliance and efficiency costs with other 

objectives, such as equity, transparency, and administrability. 

In response to your May 17, 2004, letter to the Comptroller General and 

follow-up meetings with your staffs, this report summarizes what is known 

from the academic literature about the current tax system’s compliance 

and efficiency costs. For both costs this report describes their nature, 
Page 2 GAO-05-878 Tax Policy

presents the difficulties associated with estimating them, and summarizes 

existing estimates of their magnitude.

To describe the nature of compliance costs and the difficulty in estimating 

their magnitude, we reviewed the relevant economic literature. To 

summarize the relevant cost estimates available from the literature we 

reviewed studies that present original, empirically based compliance cost 

estimates. We report on all studies that we found that estimate the 

compliance costs to individuals or businesses attributable to the current 

(post-1986) tax system. We did not make independent estimates of 

compliance costs nor did we replicate any of the studies.

To describe the nature of efficiency costs and the difficulty in estimating 

their magnitude, we reviewed the relevant economic literature. To 

summarize the relevant cost estimates available from the literature, we 

reviewed 1,567 abstracts from peer-reviewed journal articles and books 

(dating back to January 1986) and nonacademic research organization 

publications and economic working papers (dating back to January 1, 

2000) that contained some reference to taxes, costs, and efficiency. On the 

basis of reading the abstract or paper, we excluded studies that did not 

produce original empirical estimates or that made estimates for the federal 

tax system existing prior to the major 1986 tax reform. We found no study 

that comprehensively estimated the cost of all behavioral distortions 

caused by the tax system. We also consulted with experts outside of GAO, 

asking them if they were aware of studies we overlooked. We report on all 

studies that we found that estimate the efficiency costs attributable to 

selected aspects of the current system. The coauthor of one of these 

studies is a key contributor to this report. To ensure the objectivity and 

independence of this product, a second economist, within GAO, verified 

that the work in this section was presented in an accurate and unbiased 

manner. We also report on a set of studies that estimate efficiency gains 

that would result from replacing the current federal tax system with an 

alternative system that raised the same amount of revenue. As was the 

case with compliance costs, we did not make independent estimates of 

efficiency costs nor did we replicate any of the studies.

We conducted our work in Washington, D.C., from November 2004 through 

July 2005 in accordance with generally accepted government auditing 

standards. We provided a draft of this report in August 2005 to the 

Commissioner of Internal Revenue. We received technical comments via email from the IRS Office of Research. Where appropriate, we made 

changes in our report in response to these comments.
Page 3 GAO-05-878 Tax Policy

GAO is making no recommendations in this report.

Results in Brief The federal tax system imposes a wide range of recordkeeping, 

computational, and filing requirements upon businesses and individuals. 

Complying with these requirements costs taxpayers’ time and money. 

Neither the government nor taxpayers maintain regular accounts of these 

costs and many important elements of the costs are difficult to measure 

because, among other things, federal tax requirements often overlap with 

recordkeeping and reporting that taxpayers do for other purposes. 

Available estimates of aggregate compliance costs vary in terms of the 

scope of costs that they include, the tax years that are represented, 

assumptions regarding the monetary value of an hour of time spent on tax 

compliance, and other methodological factors. Although the Information 

Collection Budget for the Department of the Treasury contains the most 

comprehensive estimate, analysts both within Treasury and outside 

consider this estimate to be very uncertain because it is based on survey 

data from the early 1980s that have been updated each year with an overly 

simplified methodology. The Internal Revenue Service (IRS) is in the 

middle of a long-term research effort to improve its methodology for 

estimating compliance burden. Preliminary, partial results from that new 

effort and evidence from other researchers indicate that compliance costs 

are large, even though the total remains uncertain. For example, 

combining the lowest available (and incomplete) estimates of individual 

and corporate compliance cost yields a total of $107 billion (roughly 1 

percent of GDP) per year; however, other studies estimate costs 1.5 times 

as large. Whether compliance costs could be reduced by redesigning the 

tax system and, if so, by how much would depend upon the details of the 

new tax system, since all tax systems have compliance costs.

The tax system also results in economic efficiency costs. These costs 

occur when tax rules cause individuals to change their work, savings, 

consumption, and investment behavior in ways that ultimately leave them 

with a combination of consumption and leisure (now and in the future) that 

they value less than the combination they would have obtained under a tax 

system that did not alter their behavior. Some of the incentives to change 

behavior are intentionally designed into the tax system, others are 

unintended consequences of rules designed to achieve other objectives, 

such as equity or increased revenue yields. Estimating efficiency costs is 

very challenging because federal taxes have such extensive and diverse 

effects on behavior. In fact, we found no comprehensive estimates of the 

efficiency costs of the current federal tax system. Nonetheless, we did find 
Page 4 GAO-05-878 Tax Policy

some studies that estimate the efficiency costs attributable to selected 

aspects of that system. Although none of these studies, either individually 

or in the aggregate, provide a basis for estimating the total efficiency cost 

of the tax system, they do indicate that those total costs are likely to be 

large. The two most comprehensive studies we found show costs on the 

order of magnitude of 2 to 5 percent of GDP each year (as of the mid1990s). However, the actual efficiency costs of the current tax system may 

not fall within this range because of uncertainty surrounding taxpayers’ 

behavioral responses; changes in the tax code and the economy since the 

mid-1990s; and the fact that the two studies did not cover the full scope of 

efficiency costs. The current tax system, as well as all major alternatives, 

imposes efficiency costs. As with the case of compliance costs, the extent 

to which efficiency costs could be reduced by tax system redesign would 

depend upon the details of the new system. 

Background The current tax system in the United States consists primarily of five types 

of taxes: (1) personal income taxes; (2) corporate income taxes; (3) social 

insurance taxes (employee and employer contributions for Social Security, 

Medicare, and unemployment compensation); (4) estate and gift taxes, and 

(5) a variety of other taxes such as excise taxes on goods and services. 

Table 1 summarizes several selected features of the current federal tax 

system.

Table 1: Features of the Tax System as of July 2005

Type of tax Tax base Tax rates

Personal Income Taxes (PIT) Regular PIT

Personal income, including income from wages, 

interest and dividends, capital gains, and small 

business income. 

Numerous tax expenditures exist that reduce the 

size of the tax base.

Regular PIT

Graduated rate structure:

Statutory marginal rates of 10, 15, 25, 28, 33 percent, 

and 35 percent. Deductions and other tax 

expenditures, such as refundable tax credits, such as 

the Earned-Income Tax Credit, create a group of 

taxpayers who have no tax liability or receive an outlay 

from the tax system.

Personal Alternative Minimum Tax (AMT)

Taxable income exceeding certain threshold 

amounts based on filing status.

Personal AMT

26 or 28 percent depending on taxable income 

subject to the AMT. Eligible for a credit for a portion of 

the AMT paid in a prior year.
Page 5 GAO-05-878 Tax Policy

Source: GAO analysis of IRS information.

a

The unified transfer tax is based on the value of property to be included in a decedent’s estate at 

death and the value of taxable lifetime gifts made by the decedent. Beginning in 2004, the estate and 

gift tax applicable exclusion amounts differ.

Corporate Income Taxes 

(CIT) 

Regular CIT

Corporate profits (total revenues less total 

expenses). Numerous tax expenditures exist 

that reduce the size of the tax base.

Regular CIT

Statutory marginal rates fluctuate between 15 and 35 

percent. Due to special provisions, some 

corporations may pay a marginal tax rate of 39 

percent. 

Corporate AMT

Broader definition of the tax base (corporate 

income) than regular CIT, less generous 

accounting rules.

Corporate AMT

20 percent for all corporate income subject to the tax 

less the AMT credit for that tax year.

Social Insurance Taxes Social Security

First $90,000 of employee wages.

Social Security

6.2 percent employee contribution.

6.2 percent employer contribution.

12.4 percent for self-employed.

Medicare

All wages.

Medicare

1.45 percent employee contribution.

1.45 percent employer contribution.

2.90 percent for self-employed.

Unified Transfer Tax—

Estate, Gift, and 

Generation Skipping 

Taxa

Estate Tax

Fair market value of the decedent’s cash and 

securities, real estate, trusts, annuities, business 

interests, and other assets less allowable 

deductions in excess of $1.5 million in 2005. 

There is an unlimited deduction for transfers to a 

surviving spouse.

Estate Tax

Maximum tax rate of 47 percent in 2005. As a result 

of recent tax legislation, estate tax rates will fluctuate 

before the estate tax is eliminated in 2010. However, 

the estate tax will be reinstated in 2011.

Gift Tax

Tax is imposed on lifetime taxable transfers of 

gifts of property. Applicable exclusion amount of 

$1 million for 2005. In addition, there is an 

annual exclusion of $11,000 per donee and an 

unlimited exclusion for tuition and medical 

payments.

Gift Tax

Maximum tax rate of 47 percent in 2005. Rates 

fluctuate in the same manner as for the estate tax in 

coming years. Gift tax will be retained following repeal 

of estate and generation skipping tax.

Generation Skipping Tax (GST)

Total generation skipping transfers (such as from 

a grandparent to a grandchild) in excess of $1.5 

million in 2005.

Generation Skipping Tax

47 percent (or highest statutory marginal tax rate for 

the estate tax) in 2005. GST rates decrease until the 

tax is repealed in 2010. GST is reinstated in 2011.

Excise and Other Taxes Selected goods, services, and other items (e.g., 

gasoline, alcoholic beverages, tobacco, airline 

tickets, etc.).

Various rates apply to different goods, services, and 

other items.

(Continued From Previous Page)

Type of tax Tax base Tax rates
Page 6 GAO-05-878 Tax Policy

The definition of the tax bases, the tax rates, the various tax credits, and 

the specific characteristics of each taxpayer determine how much that 

taxpayer must pay to the U.S. Treasury. The total cost of taxes from a 

taxpayer’s point of view is the sum of the tax liability, the costs of 

complying with the tax system, and the efficiency costs that the system 

imposes, as shown in figure 1. In subsequent sections we discuss the 

various factors that cause the latter two types of costs.

Figure 1: Components of the Total Cost of a Tax to Taxpayers

Estimates of Tax 

Compliance Costs Are 

Uncertain Because 

Taxpayers Generally 

Do Not Record Them; 

However, Total Costs 

Are Likely to Be Large 

The costs of complying with the tax system are uncertain, but likely to be 

large—estimates are roughly on the order of about 1 percent of GDP. The 

costs include the computational, reporting, planning, and recordkeeping 

requirements of the tax system. Estimates of compliance costs are 

uncertain because taxpayers generally do not keep relevant records 

documenting their time and money spent complying with the tax system 

and many important elements of the costs are difficult to measure because, 

among other things, federal tax requirements often overlap with 

recordkeeping and reporting that taxpayers do for other purposes.

Taxpayers Incur Costs 

When Complying with the 

Computational, Reporting, 

and Recordkeeping 

Requirements of the Tax 

System

The federal tax system imposes a wide range of recordkeeping, planning, 

computational, and filing requirements upon businesses and individuals. 

Complying with these requirements costs taxpayers time and money. Many 

of these requirements are complex, reflecting both the complexity of our 

modern economy and intent of policymakers to build progressivity and 

various incentives into the tax system. As shown in figure 2, these costs to 

taxpayers are above and beyond what they pay to the government in taxes.

Source: GAO.

Tax liability

Total cost of 

a tax to

a taxpayer

Efficiency 

costs

 Compliance

burden + + =
Page 7 GAO-05-878 Tax Policy

Figure 2: Compliance Burden Is One Cost Taxpayers Face in Complying with the Tax 

System

The tax compliance requirements for individuals include the 

documentation of their incomes and their qualifications for various 

exemptions, deductions, and credits available under the federal income 

tax. Although the documentation of income is straightforward for a large 

proportion of the individual taxpayer population who earn only labor and 

interest income and capital income within a retirement account, 

substantial numbers of taxpayers receive income from capital gains, rents, 

self-employment, and other sources that involve additional calculations 

and recordkeeping. In addition, many individuals must familiarize 

themselves with (or pay someone to advise them on) the sometimes 

complex rules for determining whether they qualify (and, if so, to what 

extent) for any of the numerous tax benefits in the federal tax code. 

Moreover, in cases where multiple tax expenditures have similar purposes, 

taxpayers may have to devote considerable time to learning and planning in 

order to make optimal use of these tax benefits.

For example, the IRS publication Tax Benefits for Education1 outlines 12 

tax expenditures, including 4 different tax expenditures for educational 

saving. Three of these savings tax expenditures—Coverdell Education 

Savings Accounts, Qualified Tuition Programs, and U.S. education savings 

bonds—differ across more than a dozen dimensions, including the tax 

1

Department of the Treasury, IRS, Publication 970, Tax Benefits for Education, 2004.

Source: GAO.

Tax liability

Total cost of 

a tax to

a taxpayer

Efficiency 

costs

 Compliance

burden + + =

The compliance burden, or the time and resources required to comply with the tax laws– 

including out of pocket costs, are a second type of cost that taxes impose on taxpayers. 
Page 8 GAO-05-878 Tax Policy

penalty that occurs when account balances are not used for qualified 

higher education expenses, who may be an eligible beneficiary, annual 

contribution limits, and other features. Similarly, 3 other tax expenditures, 

all of which help students meet current costs—the Hope credit, Lifetime 

Learning credit, and the tuition deduction—differ in terms of eligibility 

criteria, benefit levels, and income-related phase-outs. The use of one of 

these tax expenditures can affect whether (or how) a taxpayer is allowed 

to use the other tax expenditures. Moreover, the use of one of these tax 

expenditures may affect a student’s eligibility for other forms of federal 

assistance for higher education, such as Pell grants and subsidized loans.2

Tax compliance requirements for businesses are even more extensive and 

complex than those for individuals. Rules governing the computation of 

taxable income, expense deductions, and tax credits of U.S. corporations 

that do business in multiple foreign countries are particularly complex. 

But even small businesses face multiple levels of tax requirements of 

varying difficulty. In addition to computing and documenting their income, 

expenses, and qualifications for various tax credits, businesses with 

employees are responsible for collecting and remitting (at varying 

intervals) several federal taxes on the incomes of those employees. 

Moreover, if the businesses choose to offer their employees retirement 

plans and other fringe benefits, they can substantially increase the number 

of filings they must make. Businesses also have information-reporting 

responsibilities—employers send wage statements to their employees and 

to IRS; banks and other financial intermediaries send investment income 

statements to clients and to IRS.3

 Finally, a relatively small percentage of 

all businesses (which nevertheless number in the hundreds of thousands) 

are required to participate in the collection of various federal excise taxes 

levied on fuels, heavy trucks and trailers, communications, guns, tobacco, 

and alcohol, among other products.

2

 For a fuller discussion of the difficulties that taxpayers face when trying to make use of the 

various tax expenditures for education, see GAO, Student Aid and Postsecondary Tax 

Preferences: Limited Research Exists on Effectiveness of Tools to Assist Students and 

Families through Title IV Student Aid and Tax Preferences, GAO-05-684 (Washington, D.C.: 

July 29, 2005).

3

 Although this information reporting increases the compliance burden on businesses, it 

does enable IRS to enforce tax compliance by wage earners and investors at lower cost. 

This reduction in administrative costs, which are paid out of the federal budget, means that 

taxes are slightly lower than they otherwise would have to be.
Page 9 GAO-05-878 Tax Policy

The tax filings and records of both individuals and businesses are subject 

to review by IRS. Attempts at tax evasion, unintentional filing errors, or 

differing interpretations of the tax law can all lead IRS to request more 

information from taxpayers and, possibly, to litigation, all of which would 

add to the taxpayers’ costs.

Estimates of Compliance 

Costs Are Uncertain 

Because Relevant Records 

Are Not Kept

It is difficult for researchers to estimate the total compliance costs of the 

federal tax system because taxpayers generally do not keep records of the 

time and money spent complying with that tax system. Moreover, many 

important elements of the costs are difficult to measure because

• recordkeeping and reporting to comply with federal tax requirements 

often overlap with recordkeeping and reporting that taxpayers do for 

other purposes;

• some costs that taxpayers incur in dealing with IRS may result from tax 

evasion, rather than tax compliance; and

• there is no consensus on the appropriate method for determining the 

dollar-value of each hour that an individual spends on tax compliance.

Businesses and individual taxpayers have little, if any, motivation to keep 

records of the time and money that they spend specifically on complying 

with federal tax requirements. Consequently, when researchers attempt to 

collect data on compliance costs, they typically have had to contact 

samples of taxpayers, through surveys or interviews, and ask them for their 

best recollection of the total time and money they spent on particular 

compliance activities. Evidence from one past compliance cost study 

suggests that respondent recall error may be substantial.4

 Moreover, 

conveying the appropriate definition of federal tax compliance costs to 

mail or telephone survey respondents and getting those respondents to 

apply that definition uniformly is difficult, as will be clear from the 

discussion below. In fact, most of the studies that we found had 

considerable difficulty getting taxpayers, particularly businesses, to 

4

 As part of the study that forms the basis for IRS’s current estimates of compliance costs, 

the study’s authors used two data collection methods—a mail survey and a diary study. The 

cost estimates yielded by the two methods varied significantly. The average burden of 14.8 

hours for the mail survey respondents was 78 percent higher than the average burden of 8.3 

hours reported by diary respondents.
Page 10 GAO-05-878 Tax Policy

respond at all. A high response rate is important for the accuracy of 

estimates, particularly for the population of business taxpayers that is 

highly diverse in terms of size, industry, and business organization and, 

therefore, is likely to be diverse in terms of its compliance costs.

A major difficulty in measuring compliance costs is disentangling 

accounting and recordkeeping costs due to taxes from the costs that would 

have been incurred in the absence of the federal tax system. For example, 

where the rules regarding the calculation of income for tax purposes 

coincide with the rules for determining income for financial statement 

purposes, the additional costs of taxation can be minimal. Public 

corporations must file financial statements with the Securities and 

Exchange Commission; other businesses are required to provide financial 

statements to banks and other lenders when they are seeking credit. 

Similarly, many individuals need to document their income when applying 

for mortgages or financial aid for college. Moreover, most businesses and 

individuals must comply with state, and sometimes local, income tax filing 

requirements that are often very similar to those imposed by the federal tax 

system. Consequently, if one wishes to define the compliance costs 

attributable to the federal tax system as only those costs that would not 

exist in the absence of that system, then one needs to assume what the 

requirements of state and local tax systems, as well as those of financial 

accounting systems, would look like in the absence of the current federal 

tax system and make sure that none of the costs of complying with those 

requirements are included in the estimate of federal compliance cost. The 

studies that we reviewed typically exclude normal business accounting 

costs from their definition of federal tax compliance costs; however, they 

do not exclude the costs of complying with tax requirements that are 

imposed by both federal and state governments.

Two additional definitional issues that have been discussed in the 

compliance cost literature are how to treat costs associated with either tax 

planning or tax evasion. Although tax planning expenses are excluded 

from the definitions of compliance costs established by the Paperwork 

Reduction Acts of 1980 and 1995, some studies that we reviewed do include 

such expenses in their definition of compliance costs.5

 None of the studies 

we reviewed recommended the inclusion of costs associated with illegal 

tax evasion; however, it is difficult for researchers to completely exclude 

tax evasion costs from their estimates because, in many cases, the 

5

 Pub. L. No. 96-511 (1980) and Pub. L. No. 104-13 (1995).
Page 11 GAO-05-878 Tax Policy

determination of whether a particular activity constitutes tax evasion or 

not is not made until a year or more after the activity is completed (and 

recorded in a survey).

There is no consensus among researchers regarding the appropriate 

monetary value to be assigned to each hour of time spent on tax 

compliance activities. Some of the many issues involved in the choice of 

the appropriate value are: whether to use different values for time that is 

taken away from the taxpayer’s leisure and time taken away from 

additional hours at work; whether to use different values for time spent on 

activities that the taxpayer could have paid someone to do and time spent 

on activities that only the taxpayer could do; whether to relate the value to 

each taxpayer’s own hourly wage rate or to some uniform wage rate; and 

whether to use a before-tax or after-tax wage rate. The choice of the 

monetary value of an hour spent on tax compliance obviously will have a 

substantial effect on the estimated magnitude of aggregate compliance 

costs.

Existing Estimates of the 

Compliance Costs of the 

Federal Tax System, Though 

Incomplete and Imprecise, 

Suggest Those Costs Are 

Large

The government’s Information Collection Budget (ICB), for the Department 

of the Treasury, annually estimates the time that taxpayers spend on 

prefiling and filing activities for every form issued by the Treasury. The 

vast majority of these forms are tax related. Treasury has estimated that 

during fiscal year 2004 individuals, businesses, and exempt organizations 

spent a total of 6.4 billion hours on Treasury’s forms. Treasury does not 

convert this time estimate into a monetary value. If this time burden were 

monetized at rates between $15 per hour and $30 per hour (the range used 

for individual taxpayers in the studies that we found), the total cost would 

amount to between about $100 billion and $200 billion.

Many analysts within Treasury and outside believe that the ICB estimates 

are not very accurate. The estimates are based primarily on an IRS model 

that was developed with survey data for tax year 1983. The simplicity of 

the model’s approach for updating the data each year leaves it with a very 

limited ability to adjust for changes in compliance burden resulting from
Page 12 GAO-05-878 Tax Policy

changes in tax policy or tax system administration.6 Indeed, in an effort to 

more accurately measure paperwork burden, IRS is currently developing a 

revised methodology for estimating the compliance burden individuals 

incur when complying with the U.S. tax system. The new model will reflect 

a change in the approach for measuring burden: it focuses on the taxpayer 

and the taxpayer’s characteristics rather than the forms the taxpayer uses. 

Key drivers of taxpayer burden in the model are the taxpayers’ activities 

and the method of return preparation (by a paid preparer, by the taxpayer 

with tax preparation computer software, or by the taxpayer without 

computer assistance). In addition, IRS is also working on new 

methodologies for estimating the compliance burdens of various types of 

businesses and tax-exempt entities, and the burdens associated with 

postfiling activities.

Most of the other estimates of the compliance burden that we found for 

large segments of the taxpayer population were produced by contractors to 

IRS or by analysts who used IRS’s data. The disparities among the 

estimates, their likely margins of error, and their incompleteness (few 

include postfiling costs, such as audits, and all are limited to the income 

tax) prevent a more definitive conclusion about the total compliance 

burden of the U.S tax system.

Studies we found that focus on the compliance costs of individual 

taxpayers estimate it to be between $67 billion and a little over $100 billion 

per year. The variation in these estimates is primarily attributable to the 

wide range in monetary values that the different studies apply to an hour 

spent on tax compliance activities. These studies are summarized and 

compared in table 2.

6

 The only factors used in the model are measures of return size (numbers of forms and 

attachments), form size (number of words or number of line items), the number of 

references to the tax code in forms, and instructions, and the number of line items requiring 

records. The model does not take into account new developments in tax preparation 

technology, such a personal computer software and electronic filing, nor does it 

differentiate between simple and complex types of line items on tax forms.
Page 13 GAO-05-878 Tax Policy

Table 2: Available Estimates of Tax Compliance Costs for Individual Taxpayers (Including Self-employed)

Source: GAO analysis of papers cited.

a

The abbreviations CY and TY stand for calendar year and tax year respectively.

b

The scopes of all of these studies are limited to the prefiling and filing burden associated with 

taxpayers’ own income tax returns; they do not cover costs of complying with payroll or income tax 

responsibilities with respect to any employees they may hire. None of these studies includes postfiling 

costs, such as responding to notices or providing information for audits.

c

Moody included the self-employed in his estimate for business burden. He also provided detailed 

estimates by specific tax forms. We used this form-level detail to approximate his estimate for the selfemployed and shift that amount ($20 billion) from table 3 to this table to improve comparability to the 

other studies.

d

This estimate updates a similar exercise the author undertook in 1996.

Studies we found that focus on the compliance costs of businesses 

estimate them to be between about $40 billion and $85 billion per year. 

None of these estimates include the costs to businesses of collecting and 

remitting income and payroll taxes for their employees. The accuracy of 

these business compliance cost estimates is uncertain due to the low rates 

of response to their data collection surveys. In addition, the range in 

estimates across the studies is due, among other things, to differences in 

monetary values used (ranging between $25 per hour and $37.26 per hour), 

differences in the business populations covered, and differences in the tax 

years covered. These studies are summarized and compared in table 3.

Study

(publication 

date/estimate year)a

Compliance

costs

(dollars in

billions)

Important differences in scope and 

assumptionsb Notable methodological issues

IBM/IRS 

(2003 /TY 2000)

67-99 • Covers taxpayers’ time, preparer 

fees, and any other out-of-pocket 

expenses.

• Taxpayers’ time is monetized at $15 

per hour for the low estimate and at 

$25 per hour for the high estimate.

• Based on surveys of two samples of taxpayers: 

one (in 2000) for individuals who earn only wage 

and investment income; a second (in 2001) for 

self-employed individuals.

Moody—Tax 

Foundation 

(2002 /CY 2002)c

104 • Covers taxpayers’ and preparers’ 

time but no out-of-pocket expenses.

• Taxpayers’ and preparers’ time is 

monetized at $30 per hour.

• Based on data from an IRS survey of taxpayers 

for TY 1983; the methodology for updating that 

data is simplistic and does not account for 

changes in tax preparation and recordkeeping 

technology.

Slemrod 

(2004 /TY 2004)d

85 • Covers taxpayers’ time, preparer 

fees, and any other out-of-pocket 

expenses.

• Taxpayers’ time is monetized at $20 

per hour.

• Based on the author’s informed judgment of 

accumulated research on this topic, including his 

own study of a sample of Minnesota taxpayers in 

1989 (Slemrod and Blumenthal) and the IBM/IRS 

study.
Page 14 GAO-05-878 Tax Policy

Table 3: Available Estimates of Tax Compliance Costs for Corporations and Partnerships

Source: GAO analysis of the papers cited.

a

The abbreviations CY and TY stand for calendar year and tax year respectively.

b

The scopes of all of these studies are limited to the taxpayers’ own income tax returns; they do not 

cover costs of complying with payroll or income tax responsibilities with respect to their employees.

c

This study estimated that nonprofits spent over $5 billion on compliance costs (above and beyond the 

$85 billion). None of the other studies included the costs of nonprofits.

Study

(publication date / 

estimate year)a

Compliance

costs

(dollars in

billions)

Important differences in scope and 

assumptionsb Notable methodological issues

Moody—Tax 

Foundation

(2002 /CY 2002)c

85 • Covers all corporations and 

partnerships.

• Covers taxpayers’ and preparers’ time 

but no out-of-pocket expenses; does not 

cover any postfiling costs.

• Taxpayers’ and preparers’ time is 

monetized at $37.26 per hour.

• Based on data from an IRS survey of 

taxpayers for TY 1983 (with a response rate 

of less than 38 percent); the methodology for 

updating that data is simplistic and does not 

account for changes in tax preparation and 

recordkeeping technology.

Slemrod and 

Venkatesh 

(2002 /TY 2001)

22 • Excludes the largest 1,350 corporations, 

all businesses with less than $5 million 

in assets, and all partnerships with less 

than a certain number of partners.

• Covers taxpayers’ time, preparer fees, 

and any other out-of-pocket expenses, 

including all postfiling costs.

• Costs are stated in terms of businesses’ 

actual expenses for in-house or external 

tax compliance services.

• The effective response rate for the survey 

was only 10.25 percent.

• Large discrepancies existed between the 

estimates of outside expenses given by the 

taxpayers versus those given by tax 

professionals.

• Large discrepancies existed between the 

asset sizes reported by IRS versus the sizes 

reported by the taxpayers themselves. 

(Some respondents may have reported as 

part of a consolidated group when they were 

sampled to represent only a single 

corporation.)

Slemrod 

(2004 /TY 2004)

40 • Covers all corporations and 

partnerships.

• Covers taxpayers’ time, preparer fees, 

and any other out-of-pocket expenses, 

but does not appear to cover postfiling 

costs. 

• Taxpayers’ time is monetized at $25 per 

hour.

• Represents author’s best judgment, based on 

his other studies cited in this table and an 

educated guess about the cost to small 

businesses other than sole proprietors.

Slemrod and 

Blumenthal 

(1993 /TY 1992)

Follow-up study by 

Slemrod 

(1997/TY 1996)

2 • Covers only the 1,329 largest 

corporations.

• Covers taxpayers’ time, preparer fees, 

and any other out-of-pocket expenses, 

including all postfiling costs.

• Costs are stated in terms of businesses’ 

actual personnel costs for in-house tax 

compliance activities and all costs for 

external tax compliance services.

• Response rate for the 1992 survey was 27.5 

percent.

• Slemrod (1997) did a follow-up survey in 

1996 that had a lower number of 

respondents. The overall cost estimate was 

roughly the same in each study.
Page 15 GAO-05-878 Tax Policy

Frequent changes to the tax code over time reduce the relevance of past 

estimates of compliance costs to policymakers who are interested in the 

costs of the current system. Since the comprehensive tax reform of 1986 

there have been changes to the tax code every year; many of these changes 

can be characterized as major.7

 Two examples of the numerous changes 

that have likely affected compliance burden are

• the revenue provisions of the Small Business Job Protection Act of 19968

that tightened the pension nondiscrimination rules that businesses must 

follow; and

• the creation of Hope and Lifetime credits for post-secondary education 

(in the Taxpayer Relief Act of 19979

); the fact that taxpayers must chose 

between the two credits adds to their need for tax planning.

The Extent to Which 

Compliance Costs Could be 

Reduced Depends Upon the 

Details of a Redesigned Tax 

System

The estimates presented above do not represent the potential cost savings 

to be gained by replacing the current federal tax system. Any replacement 

tax system will impose significant compliance costs of its own. Moreover, 

given that many state and local government income taxes depend upon the 

same compliance activities as the federal income tax does, taxpayers 

would still bear the costs of those activities unless those other 

governments replaced their own taxes to conform to the new federal 

system. In addition, if some of the subsidies, such as the earned income tax 

credit and the research tax credit, that are provided by the current federal 

tax system are replaced by spending programs under a reformed system, 

tax compliance costs may be reduced, but only as a result of their being 

shifted to those new programs. Similarly, if a replacement tax system no 

longer requires businesses and individuals to compute and document their 

incomes, those businesses and individuals will still need to document their 

incomes for borrowing and other purposes, and government statistical 

agencies will incur expenses to replace the data that they currently obtain 

from income tax returns.

7

 According to The President’s Advisory Panel on Federal Tax Reform, Staff Presentation on 

Complexity and Instability presented on July 20, 2005, there have been 14,400 changes to the 

tax code since 1986.

8

 Pub. L. No. 104-188 (1996).

9

 Pub. L. No. 105-34 (1997).
Page 16 GAO-05-878 Tax Policy

Efficiency Costs 

Arising from TaxInduced Changes in 

Behavior Are Likely to 

Be Large but Can Only 

Be Modeled with 

Considerable 

Uncertainty 

Economic efficiency costs occur when tax rules cause individuals to 

change their work, savings, consumption, and investment behavior in ways 

that ultimately leave them with a combination of consumption and leisure 

(now and in the future) that they value less than the combination they 

would have obtained under a tax system that did not distort their behavior. 

Estimating efficiency costs is very challenging because the tax system has 

such extensive and diverse effects on behavior. We found no 

comprehensive estimates of the efficiency costs of the current federal tax 

system. However, we did find some studies that estimate the efficiency 

costs attributable to selected aspects of the current system. Although none 

of these studies, either individually or in the aggregate, provide a basis for 

estimating the total efficiency cost of the tax system, they do indicate that 

those total costs are likely to be large. The more comprehensive estimates 

show costs on the order of 2 to 5 percent of GDP each year. However, the 

efficiency cost of the current tax system may not fall within that range 

because of uncertainty surrounding taxpayer’s behavioral responses to tax 

rules, changes in the tax code and the economy since the mid-1990s, and 

the studies do not cover all of the sources of efficiency costs. 

Efficiency Costs Arise When 

Taxpayers Alter Their 

Behavior in Response to Tax 

Rules

Many aspects of the federal tax system provide incentives or disincentives 

for taxpayers to undertake particular activities. Some of these incentives 

and disincentives were intentionally designed into the system; others are 

unintended consequences of rules designed to achieve other objectives, 

such as equity or increased revenue yield. By changing the relative 

attractiveness of highly taxed and lightly taxed activities, taxes alter 

decisions such as what to consume and how to invest. Households and 

firms generally respond to taxes by choosing more of lower taxed items 

and less of higher taxed items than they would have otherwise. When 

taxpayers alter their behavior in response to tax rules, they often end up 

with a combination of consumption (broadly defined) and leisure that they 

value less than the combination they could have achieved if they made 

decisions free of any tax influences. Economists refer to this reduction in 

value as a “welfare loss” or an efficiency cost; they also generally refer to
Page 17 GAO-05-878 Tax Policy

behavioral changes in response to taxes as “distortions,” even though not 

all changes have negative consequences. 10

Figure 3: Efficiency Costs Are One Cost Taxpayers Face in Complying with the Tax 

System

As an example of the efficiency costs of taxes, suppose an investor is 

choosing between two potential investments, one that has an expected 

return of $1.10 on every dollar invested and a second that has an expected 

return of $1.20. If neither investment is taxed, or if the investments are 

taxed equally, the investor will choose the second investment with its 

higher economic rate of return. However, if the first investment continues 

to be untaxed, while the second is subject to a 10 percent tax, the decision 

will be based on the investments’ after-tax rates of return. In this case the 

after-tax return on the first investment continues to be $1.10 for every 

dollar invested, while the after-tax return on the second investment is now 

$1.08. An investor would choose the first investment because it has a 

higher after-tax return. This tax distortion causes investors to earn $.10 

less on every dollar invested, relative to the no-tax case, even though no tax 

is paid to the government. This decline in income ultimately leads to lower 

total consumption.

10 A tax on pollution is an example of an efficiency-enhancing tax that causes a beneficial 

change in behavior. Pollution may be viewed as a negative product that consumers are 

involuntarily forced to consume. A tax on pollution can provide polluters with an incentive 

to reduce their emissions, thereby increasing the well-being of consumers. 

Source: GAO.

Tax liability

Total cost of 

a tax to

a taxpayer

Efficiency 

costs

 Compliance

burden + + =

In addition to the tax revenue collected and the compliance burden of taxation, taxes 

generate efficiency costs that reduce people's well-being. These efficiency costs can 

come in the form of lost output or consumption opportunities.
Page 18 GAO-05-878 Tax Policy

Efficiency gains or costs are not the same as increases or decreases in 

economic output (normally measured in terms of GDP). For example, a 

reduction in taxes on wages could encourage some individuals to increase 

the number of hours they work, which in turn would increase economic 

output and the amount of consumption those workers could achieve. 

However, the welfare gain to these individuals may be considerably less 

than the increase in their consumption because they would have to forego 

some leisure time that they value in order to achieve the gain in welfare. In 

fact, some researchers who have examined both the output and efficiency 

effects of replacing the current tax system with various alternatives have 

reached similar conclusions concerning output effects while reaching 

different conclusions concerning the efficiency effects of similar 

alternatives.11 

The efficiency gain or loss due to a change in a tax system is defined as the 

difference between total welfare that is achieved under the existing tax 

system and that which would be achieved under the replacement system 

that raised the same amount of revenue. The total efficiency cost of the 

current federal tax system would have to be estimated by comparing it to a 

tax system that raised the same amount of revenue while generating no 

efficiency costs at all—in other words, a tax system that had no effect on 

taxpayers’ behavior at all. Although such distortion-free tax systems can 

be designed in theory, none exist as primary sources of revenue in practice 

because they are generally viewed as inequitable.12

11 For example, both Jorgenson and Yun, Investment Volume 3: Lifting the Burden: Tax 

Reform, the Cost of Capital, and U.S. Economic Growth, (Cambridge, Massachusetts, MIT 

Press, 2001) and Alan Auerbach, “Tax Reform, Capital Allocation, Efficiency and Growth,” 

in Economic Effects of Fundamental Tax Reform (Washington, D.C., Brookings Institution 

Press, 1996) examine the output and efficiency effects of changing to a consumption-based 

tax. While they both find significant output effects, only Jorgenson and Yun consistently 

find large efficiency gains from switching to a consumption tax.

12 A head tax, which is a tax that collects the same amount of money from all taxpayers 

regardless of how much they earn or consume, is an example of a tax that does not distort 

behavior. This type of tax does not meet either of the two commonly recognized criteria for 

equitable taxes—first, that tax liabilities should be related to taxpayers’ ability to pay and, 

second, that tax liabilities should reflect the benefits that taxpayers receive from the 

government.
Page 19 GAO-05-878 Tax Policy

Estimates of Efficiency 

Costs Are Highly Uncertain 

Because the Tax System Has 

Such Extensive and Diverse 

Effects on Behavior

Estimating the efficiency costs of the federal tax system is an enormous, 

complicated, and uncertain task, given the complexity of existing tax rules, 

the breadth and diversity of the U.S. economy and population, and the 

limited empirical evidence available regarding how individuals and 

businesses change their behavior in response to tax rules. In order to 

obtain a precise estimate of the efficiency costs researchers would need to 

identify all of the significant incentives and disincentives imbedded in the 

federal tax system; they would also need to know the extent to which large, 

heterogeneous populations of individuals and businesses have changed 

their behaviors in response to these incentives.13

In practice, researchers have not been able to obtain and analyze all of the 

detailed data they need to produce efficiency cost estimates that are free 

from a large degree of uncertainty. The mathematical models that are used 

to analyze the important interrelating and cascading effects of the entire 

tax system, or even significant components of the system, are quite 

complex, even when researchers limit their examination to highly 

simplified representations of the actual taxes. It is impractical to 

incorporate all of the significant details of tax rules that result in efficiency 

costs. Similarly, data constraints and computational practicality lead 

researchers to limit the extent to which their models reflect the variations 

in behavioral responses to various tax rules across large and 

heterogeneous populations of businesses and individuals. Finally, 

researchers attempting to estimate efficiency costs often have little, or 

conflicting, empirical evidence upon which to base their assumptions 

about various behavioral responses to tax distortions because the 

underlying research into those behavioral responses is, itself, subject to 

considerable uncertainty. For example, one piece of information that is 

critical to the estimation of efficiency costs is the extent to which 

individuals’ taxable incomes change in response to tax changes. 

Researchers have had difficulty estimating this responsiveness because of 

the difficulty of controlling for all of the other factors that affect income 

growth, such as changes in the economic environment, returns to 

investments in education, and the changing age distribution of the 

13 Moreover, it is not sufficient simply to know how various tax incentives directly distort an 

individual’s or business’ decisions. The researchers would also need to know how those 

distorted decisions, in turn, caused other decisions to be distorted in a cascading effect. For 

example, the distortion of savings decisions can affect the amount of investment in the 

economy, which in turn can affect the productivity of labor and, therefore, the wage rate 

paid to labor (which generally is directly related to the productivity of labor). The change in 

the wage rate then affects individuals’ choices between work and leisure.
Page 20 GAO-05-878 Tax Policy

population. Moreover, this responsiveness is likely to be different for 

different subpopulations of taxpayers.14

While No Comprehensive 

Estimates of the Tax 

System’s Efficiency Costs 

Exist, Available Partial 

Estimates Suggest Those 

Costs Are Large

None of the studies we reviewed provides a comprehensive estimate of the 

efficiency cost of the U.S. federal tax system since the tax reform of 1986. 

However, a variety of studies do provide some evidence that the efficiency 

costs are large. All of these studies are summarized in table 4. The more 

comprehensive studies we found show costs on the order of 2 to 5 percent 

of GDP each year (as of the mid-1990s). The other studies that we 

reviewed examined more limited aspects of the tax system’s distortions. 

The efficiency cost estimates for those selected distortions cannot be 

summed directly to an overall estimate; however, they are each significant 

enough to support the conclusion that the combined cost of all distortions 

is large. 

Table 4: Estimates of the Efficiency Gains from the Removal of Selected Distortions in the Current Tax System

14 Seth Giertz, Recent Literature on Taxable Income Elasticities, Congressional Budget 

Office Technical Paper Series, number 2004-16, December 2004.

Tax(es) included in

the study Behavior altered

Feldstein (1999)

Employs his own estimates of the responsiveness of taxable income to 

tax changes and those of other researchers to estimate the efficiency 

gains from replacing personal income and payroll taxes with revenueneutral nondistorting taxes. Estimated efficiency costs of $137 billion to 

$363 billion in 1994. The author recognizes that the responsiveness of 

taxable income to changes in taxes is a key parameter, subject to 

ongoing research and that a range of estimates exist. This cost recurs 

each year.

Personal Income Tax 

Payroll Tax

Work versus leisure

Tax-preferred 

consumption (e.g., fringe 

benefits) versus other 

consumption

Gravelle (2004, 1989)

Gravelle and Kotlikoff (1993)

Simulates how taxes affect the allocation of capital investment across 

the corporate and noncorporate sectors. Estimated efficiency costs of 

nearly $13 billion in 1988, based upon one set of assumptions. This 

cost recurs each year. In 2004, the author notes that the subsequent 

reduction in taxes on dividends has contributed to a decrease in the 

efficiency cost from the corporate/noncorporate distortion. 

Personal Income Tax

Corporate Income Tax

Corporate versus 

noncorporate 

investment
Page 21 GAO-05-878 Tax Policy

Source: GAO analysis of papers cited.

Cai and Gokhale (1997)

Estimates how taxes on capital income distort decisions about when 

and what to consume. Estimated efficiency costs of $45 billion in 1995, 

in the authors’ base-case. The authors note that the distortion can be 

substantial for the consumption of durable goods, such as housing, 

which have relatively low rates of depreciation. This cost recurs each 

year.

Selected Aspects of the 

 Personal Income Tax

Selected Aspects of the 

 Corporate Income Tax

Current consumption 

 versus savings 

Durable consumption 

 versus nondurable 

 consumption

Lui and Rettenmaier (2002, 2004)

Estimates the excess burden of the Social Security payroll taxes using 

two estimates of labor supply responsiveness. Estimated efficiency 

costs range from $49 billion to $82 billion in 2001, depending on the 

degree of labor supply responsiveness assumed. The authors note that 

their estimates do not include impacts of payroll taxes on savings 

decisions or tax-preferred consumption. This cost recurs each year. In 

the second paper the authors suggest an alternative derivation of the 

excess burden, which produces estimates that are 10 to 50 percent of 

the original.

Social Security Payroll 

 Tax

Work versus leisure

Holtz-Eakin and Marples (2001a, 2001b)

Estimates the efficiency cost associated with the distortion of wealth 

accumulation decisions by the estate tax relative to a uniform tax on 

capital income. Estimated efficiency cost of $38.4 billion in 1999, using 

the authors’ preferred set of assumptions. The authors note that their 

data exclude the “super-rich” who are most affected by the tax and that 

the literature on the percentage of bequests that are intentional 

presents a large range of estimates. This cost recurs each year.

Estate Tax Wealth accumulation 

 and allocation to 

 bequests versus lifetime 

 consumption and 

 other lifetime uses of 

 wealth

Jorgenson and Yun (2001)

Estimates the efficiency cost of replacing the personal and corporate 

income tax with a nondistortionary revenue neutral tax. Estimated 

efficiency costs at the local, state, and federal level of 19.5 percent of 

combined collections. If applied to only federal collections, this would 

equal about $200 billion in 1997. 

Personal and Corporate Income

Taxes at the Federal, State, 

and Local level

Behaviors altered by 

 the personal income 

 tax, such as savings, 

 work effort, and 

 housing choices; and 

 behaviors altered by 

 the corporate income 

 tax, such as debt 

 versus equity finance, 

 organizational form, 

 and dividend 

 decisions.

(Continued From Previous Page)

Tax(es) included in

the study Behavior altered
Page 22 GAO-05-878 Tax Policy

The two studies with the broadest scopes among those that we reviewed 

were by Jorgenson and Yun and by Feldstein.15 The first set of authors 

estimated that the efficiency cost of federal taxes on capital and labor 

income in 1997 was equal to about 19.5 percent of the revenues collected 

from those taxes.16 Applying this percentage to federal corporate and 

personal income tax collections in 1997 would yield efficiency costs of 

about $200 billion or, roughly, 2.5 percent of GDP in that year. Feldstein 

examined the effects of several distortions caused by the federal personal 

income tax and payroll taxes, including those related to decisions about 

how much to work and what to consume. He estimated that these 

distortions resulted in efficiency costs of between $137 billion and $363 

billion in 1994 (depending on his assumptions regarding the size of taxes 

effects on various decisions). Those estimates were roughly equivalent to 

between 2 and 5 percent of GDP in 1994.

The other studies that we found focused on more limited aspects of the tax 

distortions caused by the federal tax system. For example, Cai and 

Gokhale examined how selected aspects of the federal personal and 

corporate income taxes distorted the choices between savings and 

consumption and found that these distortions generated $45 billion per 

year in efficiency costs as of 1995. As another example, Holtz-Eakin and 

Marples found that the distorting effect of the estate tax on choices among 

consumption, leisure, and wealth accumulation resulted in efficiency costs 

of over $38 billion in 1999. 

The estimates from the various studies shown in table 4 cannot be 

combined to obtain a comprehensive estimate of the current tax system’s 

efficiency costs for several reasons. First, no combination of the estimates 

covers all of the tax system’s distortions (e.g., none of the estimates cover 

the effects of payroll taxes on savings). Second, an estimate of the costs 

arising from all of the tax system’s distortions can only be made by

15 Jorgenson and Yun 2001 and Martin Feldstein, "Tax Avoidance and the Deadweight Loss of 

the Income Tax," The Review of Economics and Statistics, 1999.

16 The authors actually estimate the cost of these taxes at the federal, state, and local level; 

however, one of the authors told us that the costs as a percentage of revenue should be 

approximately the same if the state and local taxes were excluded from the analysis.
Page 23 GAO-05-878 Tax Policy

examining the removal of all of the distortions simultaneously.17 Finally, 

the various estimates are made for different years and, therefore, reflect 

different tax systems, each of which is somewhat different than today’s 

system. As noted earlier, there have been frequent and significant changes 

to the tax system since 1986. Even as recently as 2001 and 2003 there have 

been changes that are likely to have affected the efficiency costs of federal 

income taxes. For example, the Economic Growth and Tax Relief 

Reconciliation Act of 2001 (EGTRRA)18 decreased the marginal tax rates on 

individual income and estates and increased the exemption from estate 

taxes. These changes could have decreased the efficiency cost for 

individuals. Also, Gravelle (2004) notes that the temporary reduction in 

taxes on dividends contained in the Jobs and Growth Tax Relief 

Reconciliation Act of 200319 contributed to a reduction of the 

corporate/noncorporate distortion and its efficiency costs. Nevertheless, 

the estimated efficiency costs associated with the selected distortions are 

significant enough individually to suggest that the total efficiency cost of 

the tax system is large. 

We also reviewed a number of other studies that estimated the difference in 

efficiency costs between existing federal income taxes and potential 

substitutes for those taxes.20 These estimates do not represent the absolute 

costs of the existing taxes because the substitute taxes all generate 

efficiency costs of their own; however, they would (to the extent that they 

are accurate) represent lower bounds for those costs. The findings of these 

studies varied considerably, depending on the nature of the taxes that were 

presumed to replace the federal income taxes. For example, Lim Rodgers 

17 For example, Douglas Holtz-Eakin and Donald Marples, “Distortion Costs of Taxing 

Wealth Accumulation: Income Versus Estate Tax," National Bureau of Economic Research 

Working Paper 8261, 2001, estimated the efficiency costs of the estate tax in the presence of 

all of the distortions associated with the federal income taxes. Their estimate could have 

been significantly different if they had assumed that a nondistortionary tax had been in 

effect at that time, instead of the income taxes. For this reason, it is inappropriate to 

assume that eliminating the distortions of the estate tax would have yielded the same $38.4 

billion in 1999 on top of the gains that Jorgenson and Yun 2001 estimate could have been 

realized by removing all income tax distortions. 

18 Pub. L. No. 107-16 (2001).

19 Pub. L. No. 180-27 (2003).

20 In addition, a number of studies have estimated the effects of fundamental tax reform on 

economic output. However, as we noted previously, output effects are not the same as 

efficiency effects, so those output estimates are not relevant to the questions addressed in 

this report.
Page 24 GAO-05-878 Tax Policy

and Jorgenson and Wilcoxen found that there would be little, if any, 

efficiency gain from replacing the existing income taxes with a 

consumption-based flat tax.21 In contrast, Jorgenson and Yun estimated 

that the efficiency gains of replacing income taxes with a pure flat-rate 

income and/or sales tax would yield gains of about $210 billion per year 

(measured in 1997 dollars).22

As noted earlier, considerable uncertainty surrounds all of the estimates we 

have cited. The estimation of efficiency costs involves complicated 

modeling based on numerous assumptions about the behavioral responses 

of individuals and businesses to changes in taxes and other factors. 

Results are often quite sensitive to the assumed magnitude of key 

responses and those assumptions are often based on empirical research 

that continues to evolve over time or, in other cases, has yet to be 

undertaken. For example, the consensus of recent research is that 

individuals are less responsive to changes in taxes than Feldstein assumed 

them to be when he made his estimates. As another example, Holtz-Eakin 

and Marples noted that there was significant disagreement in the empirical 

research over one of the factors that was key to their estimate—the extent 

to which actual bequests differed from intended bequests.

The Extent to Which 

Efficiency Costs Can be 

Reduced by Tax System 

Redesign Is Uncertain

As some of the results presented in the preceding section demonstrate, the 

extent to which efficiency gains could be realized by switching to an 

alternative tax system depends critically on the detailed characteristics of 

the alternative. All of the alternative tax system proposals that have 

received serious consideration in recent decades would have imposed 

significant efficiency costs. Moreover, in assessing the potential efficiency 

gains from any tax reform proposal it is also important to consider 

compensating changes that may be made on the spending side of the 

federal budget. For example, if any tax expenditures in the current federal 

income taxes are replaced by grants, spending programs, regulations, or 

21 The characteristics of this replacement tax were specified by the Joint Committee on 

Taxation as part of an exercise for a symposium that the committee organized to test the 

feasibility of incorporating macroeconomic effects in revenue estimates. See JCS-21-97, 

“Joint Committee on Taxation Tax Modeling Project and 1997 Symposium Papers,” 

November 20, 1997, for a complete description.

22 These replacement taxes in Jorgenson and Yun 2001 are “pure” in the sense that they have 

no exemptions (except for investment goods in the case of the sales tax), deductions, 

credits, or special rates.
Page 25 GAO-05-878 Tax Policy

other forms of nontax subsidies, those subsidies can result in efficiency 

costs similar in magnitude to those associated with the tax expenditures 

they replaced.

Agency Comments and 

Our Evaluation

We provided a draft of this report in August 2005 to the Commissioner of 

Internal Revenue. We received technical comments via e-mail from the IRS 

Office of Research. Where appropriate, we made changes in our report in 

response to these comments.

As agreed, unless you announce the contents of this report earlier, we plan 

no further distribution until 30 days from the date of this report. At that 

time, we will make copies available to others on request. In addition, the 

report will be available at no charge on the GAO Web site at 

http://www.gao.gov. 

If you or your staff have any questions on matters discussed in this report 

or would like additional information, please contact me at (202) 512-5594 

or whitej@gao.gov. Contact points for our Offices of Congressional 

Relations and Public Affairs may be found on the last page of this report. 

Key contributors to this report were James Wozny and Donald Marples.

James R. White

Director, Strategic Issues
Page 26 GAO-05-878 Tax Policy

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