Tax Policy: Summary of Estimates of the Costs of the Federal Tax System
Published: 2005-08-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: 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.
section_title: What GAO Found
paragraphs: 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.

section_title: Letter
paragraphs: 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,  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 e- mail from the IRS Office of Research.  Where appropriate, we made  changes in our report in response to these comments.
GAO is making no recommendations in this report.
subsections: section_title: Background
paragraphs: 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.
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.
section_title: Estimates of Tax Compliance Costs Are Uncertain Because Taxpayers Generally Do Not Record Them; However, Total Costs Are Likely to Be Large
paragraphs: 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.
subsections: section_title: Taxpayers Incur Costs When Complying with the Computational, Reporting, and Recordkeeping Requirements of the Tax System
paragraphs: 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.
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 Education 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  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.
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.  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.
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.
section_title: Estimates of Compliance Costs Are Uncertain Because Relevant Records Are Not Kept
paragraphs: 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.  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  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.  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  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.
section_title: Existing Estimates of the Compliance Costs of the Federal Tax System, Though Incomplete and Imprecise, Suggest Those Costs Are Large
paragraphs: 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 changes in tax policy or tax system administration.  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.
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.
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.  Two examples of the numerous changes  that have likely affected compliance burden are  the revenue provisions of the Small Business Job Protection Act of 1996  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 1997); the fact that taxpayers must chose  between the two credits adds to their need for tax planning.
section_title: The Extent to Which Compliance Costs Could be Reduced Depends Upon the Details of a Redesigned Tax System
paragraphs: 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.
section_title: Efficiency Costs Arising from Tax- Induced Changes in Behavior Are Likely to Be Large but Can Only Be Modeled with Considerable Uncertainty
paragraphs: 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.
subsections: section_title: Efficiency Costs Arise When Taxpayers Alter Their Behavior in Response to Tax Rules
paragraphs: 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 behavioral changes in response to taxes as “distortions,” even though not  all changes have negative consequences.
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.
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.
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.
section_title: Estimates of Efficiency Costs Are Highly Uncertain Because the Tax System Has Such Extensive and Diverse Effects on Behavior
paragraphs: 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.
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  population.  Moreover, this responsiveness is likely to be different for  different subpopulations of taxpayers.
section_title: While No Comprehensive Estimates of the Tax System’s Efficiency Costs Exist, Available Partial Estimates Suggest Those Costs Are Large
paragraphs: 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.
The two studies with the broadest scopes among those that we reviewed  were by Jorgenson and Yun and by Feldstein.  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.  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 examining the removal of all of the distortions simultaneously.  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) 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 2003 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.  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  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.  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).
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.
section_title: The Extent to Which Efficiency Costs Can be Reduced by Tax System Redesign Is Uncertain
paragraphs: 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  other forms of nontax subsidies, those subsidies can result in efficiency  costs similar in magnitude to those associated with the tax expenditures  they replaced.
section_title: Agency Comments and Our Evaluation
paragraphs: 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.
section_title: Bibliography
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