Cost of Tax Compliance
A 2005 Tax Foundation study
on the cost of complying with our incredibly complex tax code estimated that individuals, businesses and nonprofits would spend an estimated 6 billion hours complying with the federal income tax code and an estimated compliance cost of over $265.1 billion. The compliance cost is an estimate based on the time spent on tax preparation valued at the compensation rate of the filer or his tax professional. This represents about 22% of federal income taxes and is equivalent to more than half the revenue of Wal-Mart
. The time spent working on taxes is equivalent to a workforce of 2.8 million workers, which is about the same as the number of soldiers, sailors and airmen in the US military on active duty and in the reserves.
Italy Calls in Military to Protect Tax Collectors
Essentially, our tax code has created the equivalent of a large second army that has been fighting a costly war for longer than any other war in American history. And the costs have been increasing. You can think of the IRS and its workforce as the equivalent of the Pentagon, which provides direction and control of the army. The accountants, tax attorneys, and other tax professionals are the junior officers, NCOs and regular soldiers following orders and participating in the tax battles and skirmishes that take place all year long. The rest of us, small business owners and individual taxpayers, are the part-time reserves and militia providing part-time service when the tax army mobilizes for its annual spring offensive every April.
Income Distribution of Tax Compliance Costs
In monetary terms, for every dollar in taxes you pay, the equivalent of 22 cents is wasted. These costs do not even include the additional costs of tax planning, tax audits and litigation. This burden falls more heavily on small businesses and individuals who earn the lowest amount of income when measured as a percentage of their income. This is because they file most of the tax returns. Larger corporations and wealthier individuals may have higher compliance costs, but they also earn more, so it is a lower fraction of what they earn. Therefore, tax simplification would most help those who pay the least in taxes. Nobel Laureate economist Gary Becker
provides an excellent overview of the economics of tax complexity
Tax Compliance Costs per Employee
The Tax Foundation study estimates costs based on the value of your time. Certainly, your time, or the money you spend having someone else prepare your taxes, has value. But how does that compare with more concrete costs? For reference, the 2013 budget request for the IRS is $12.9 billion. Intuit, maker of Turbotax and other accounting software and services, earned $4.15 billion in 2012. H&R Block, a large tax preparation company, earned $3.04 billion in 2012. These are certainly a lot less than the tax compliance cost estimates above, but also do not take into account other costs.
The actual cost of salaries, equipment, or software paid for in-house accountants or attorneys who work on tax-related recordkeeping or preparation is unknown. According to the US Bureau of Labor Statistics, average annual employment in tax preparation services was 113,000 in 2009, but this excludes Certified Public Accountants and companies that provide accounting, bookkeeping, billing, or payroll processing services in addition to tax preparation services.
For reference, here is a sample of relevant 2010 job and income statistics:
Tax examiners, collectors and revenue agents: 74,500 jobs at a median $49,360 per year
Tax preparers: 59,180 jobs at a median $39,410 per year
Personal financial advisors: 206,800 jobs at $64,750 per year
Accountants and auditors: 1.2 million jobs with a median pay of $61,690 per year
Bookkeeping, accounting, and auditing clerks: 1.9 million jobs at $34,030 per year
Financial examiners: 29,300 jobs at a median $74,940 per year
Financial managers: 527,100 jobs at a median $103,910 per year
Financial analysts: 236,000 jobs at a median $74,350 per year
The above occupations account for over 4 million jobs and $233 billion in salaries. While only a fraction of the people in some of these occupations work on tax planning and preparation, the direct economic cost of tax preparation and management, including private and government salaries, equipment, software, and other expenses, but not counting the cost of your time, has got to at least be in the tens of billions, if not much, much more.
Tax Compliance Costs
Of the 140 million individuals and families who file tax returns each year in America, 60% pay someone else to fill out forms for them, while 29% buy tax-preparation software or online services. It is possible that automated electronic tax preparation and filing software has and will continue to reduce tax preparation costs for small businesses and individuals. However, tax complexity still requires more time spent on tax preparation and planning that would otherwise be necessary.
How many of you dread the process of filing a tax return and worry about paying too much because you didn’t know about some special deductions you might have been able to take advantage of? It is extremely likely that many people do not take advantage of legal deductions. Research by the Government Accountability Office and Internal Revenue Service indicates that between 15% and 25% of households who are entitled to the Earned Income Tax Credit do not even claim their credit, or between 3.5 million and 7 million households. Simultaneously, others are able to fraudulently claim a credit.
Another side effect of tax system complexity is an increased ability to evade taxes through use of loopholes. The more complex the system, the harder it becomes to detect fraud or the more it costs to monitor tax returns and other tax-reporting data.
Is there a way to reduce these tax compliance costs and put the money back to productive use? Of course, but special interests will fight it every step of the way because everyone is looking out for their own self interest. Most of the lobbying comes from large businesses and tax-exempt charities. So, it makes sense to take them completely out of the equation by eliminating all income taxes on organizations and passing through all taxes to the individuals who earn the profits. If large organizations have no interest in the tax code, they will not try and influence legislators to give them special exemptions. This will help stop the practice of using the tax code as a system for rewarding those who are able to convince legislators to give them special benefits. After all, large organizations are just collections of individuals who are the ultimate beneficiaries of any profits they earn. Corporate taxes are just taxes that could be passed through to individual investors, where they can be taxed at their appropriate rate, without all the corporate tax manipulation.
IRS Revenue Sources
Automation will also help to reduce compliance costs as well as tax evasion. Sales taxes are fairly well automated, although elimination of all sales tax exemptions would make it even more so. Tax-exempt charities will have to pay sales taxes. An agreement between states to resolve the issue of inter-state sales taxes would eliminate the complexity of sales versus use taxes and provide businesses with a simpler way of collecting and reporting sales taxes. For instance, everyone should pay either an in-state sales tax or a flat inter-state sales tax.
I know this sounds like just another tax, but the objective is to reduce overall rates, not to generate more revenue. The inter-state tax could be distributed to the states according to where the purchasers reside, thus effectively enforcing the “use taxes” that most states have on the books but cannot currently enforce. Overall, the result will not be an increase or decrease in tax rates, but a more efficient system that will reduce the burden on businesses and end the inter-state fights over sales and use taxes.
The payroll tax is already a highly automated method for collecting income taxes. However, better automation of all forms of income, including automatic withholding of investment income, would help to make automatic year-end calculation of income taxes possible. If income tax calculation were simple enough to be automatic at the end of the year, the cost of tax compliance would plummet.
What about income from cash transactions? We know that cash-based businesses are notorious for under-reporting income. We can’t just eliminate cash, even though there are other fringe benefits. Studies show that paper money is costly to produce and also tends to carry bacteria that can make you sick. The growing use of electronic payments is already quickly reducing the number of cash transactions. We could further encourage this trend by providing tax benefits to anyone who uses such forms of payment.
For instance, electronic transaction networks could be required to collect, report, and deposit all sales and use taxes. This would help businesses by automating and eliminating their sales tax-collection burden. At the end of each month, the amount of sales tax paid could be automatically applied to each individual’s income tax withholding as a deduction. If they are in a low-income bracket, they will finally gain a benefit that high-income earners normally get when they itemize deductions. Those who end up with a credit could opt to have it deposited into an investment account or receive an automatic electronic refund.
Any other remaining expenses that are tax deductible, such as home mortgage interest and refinancing costs, or state and local taxes, should be automatically credited to an individual or joint tax account, with excess payments invested or refunded monthly. Any other forms of investment income should, similarly, be collected automatically and invested or refunded monthly. At the end of the year, a simple income tax calculation will be automatic.
This kind of automation and simplification is desperately needed. Special interests will fight it because they only care about themselves, but the overall effect will be to lower average rates by eliminating loopholes, tax evasion and tax compliance costs. Will it be fair? There is no such thing, so let’s stop talking about fair and start talking about what is efficient, reasonable, and transparent enough that people finally know what they are paying in comparison to everyone else.
Putting wasted assets to more productive use will make America stronger and more competitive with the rest of the world. Higher standards of living come from increases in productivity and are dragged down by waste and inefficiency. We are capable of amazing technical feats, so I’m confident we can design a simple, efficient, progressive tax system that will take more from the wealthy, but not enough to reduce the incentive to produce or to take extraordinary measures to avoid or evade taxes. Imagine if we could redirect some of the billions of dollars in annual compliance costs to pay down the national debt? Is that worth your vote? Does anyone in government have the guts to push for a revolutionary simplified tax system that can achieve this goal?
I don’t want to end this with nothing to show for it but a bunch of useless complaining. What is the point of complaining about something if you don’t have something better in mind? So, here are a few simple, yet revolutionary, recommendations on how to rebalance the tax system and thereby our economic and political system. Politics is all about money and power, so let’s start by talking about where our tax money comes from. It might not be what everyone agrees is fair, but at least it will be simple, transparent, and efficient, without a lot of waste or hidden loopholes. I don’t really believe there will ever be such a thing as a “fair” tax code, but if there were, this would be a big leap in that direction.
It’s time to stop fighting a tax war and demobilize the tax army. Support our tax troops by bringing them home! What will all those IRS workers, tax accountants, tax attorneys and other full-time tax professionals do when they lose their jobs in the tax army? How about a new GI Bill to get them into new and productive jobs that will make our country even stronger!
Bring the Tax Army Home!