Tax compliance costs and related issues

It is well known that the U.S. income tax system has enormous compliance costs.  Economists generally view compliance costs as the sum of direct payments made to tax lawyers and tax accountants for tax-related services plus the opportunity cost of time spent by everyone else.  Everyone else basically includes firms and individuals who complete their own tax forms and deal directly with the IRS with respect to tax audits and litigation (rather than employ tax professionals to do the “dirty work” for them). A cursory survey of the tax compliance literature yields estimates (based upon this specific compliance definition) ranging from $200 to $300 billion, or approximately 1.7 to 2.5% of GDP. 

In 2002, it is estimated that individuals, businesses and non-profits spent 5.8 billion man-hours complying with the federal income tax code, which is the financial equivalent of imposing a 20.4-cent surcharge for every dollar that the income tax system collects.  Apparently it is quite expensive to figure out what taxable income actually is.  This is not surprising in light of the substantial and growing complexity of the Internal Revenue Code.  The number of words in the Internal Revenue Code that specifically address the topic of income taxation has grown from 172,000 words in 1955 to 982,000 by 2000, an increase of 472 percent. Income tax regulations, which provide taxpayers with the “guidance” they need to calculate their taxable income, have grown at an even faster pace from 572,000 words in 1955 to 5,947,000 words by 2000, an increase of 939 percent. Combined, the federal income tax code and regulations grew from 744,000 words in 1955 to 6,929,000 by 2000—an increase of 831 percent.  (Source: “The Cost of Tax Compliance”).

Interestingly, the CNNMoney website published an article yesterday that points out another yet another important cost related to the current U.S. income tax system that is of a similar order of magnitude as the cost of compliance.  This relates to the cost of noncompliance.  Preliminary findings from a recently published IRS study show that the gap between what’s owed and what’s actually paid is between $257 billion and $298 billion (see the article entitled  “Taxpayers stiff IRS by nearly $300B”).  So let’s summarize.  The current U.S. income tax system has substantial transactions costs (1.7 to 2.5% of GDP) and at the same time produces a net shortfall of tax revenues to the government of a similar order of magnitude (i.e., an additional 2.1 to 2.5 percent of GDP).  Relative to the amount of money actually collected by the IRS, these costs total around 40%.

In the risk management literature, it is well known that the asymmetric nature of the corporate income tax creates incentives for firms to prefer hedging over retaining risk.  Tax asymmetries derive from two important features of the corporate income tax; specifically, tax rate progressivity and incomplete tax loss offsets.  Thus the incentives conveyed by the manner in which the tax system is structured creates yet another cost; specifically, firms and individuals have a tendency to underinvest in risky (but potentially profitable) assets, which in turn limits the economy’s prospective growth potential.   Thus the current U.S. income tax system gives rise to underinsvestment problems in the economy and is also very costly to administer.

Clearly, very powerful vested economic interests (with lots of money to “invest” in lobbyists) prefer the status quo, so it will be interesting to see whether Congress is able to reform the tax system such that administrative costs are substantially reduced and economic incentives with respect to risk bearing are less distorted.  Most of the proposals (e.g., a “flat” income tax or a consumption tax) that are on the table presently have the potential (at least in theory) to accomplish both of these goals, which in turn would bode well for the future growth and competitiveness of the U.S. economy.

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