A Lottery You Don’t Want to Win

Taxpayers are receiving mixed signals from Washington, D.C. Recently, Treasury Secretary Paul O’Neill announced his distaste for the complexities of the current tax code, sparking hope that there will be serious discussions of fundamental tax reform once the dust from November’s elections settles. Streamlining the tax code can reduce the burden as well as the administrative and compliance costs of the current tax code. At the same time, however, the Internal Revenue Service is moving forward with a project referred to simply as the “National Research Project.” This nondescript title masks the burden that will befall taxpayers selected to “participate” in the program, with the grand prize being an excruciating line-by-line audit.

The question of complexity and the audits are not unrelated issues. In fact, the need for audits arises from the code’s complexity. In an attempt to better understand how taxpayers may underpay due to evasion or simple mistakes, the IRS announced last January that its auditors would begin an information collection campaign sometime this fall. A simpler, more transparent tax code, however, would eliminate the need for such intrusive investigations by the IRS. Mistakes would be reduced and questionable tax dodges more readily spotted.

Yet because we are stuck with a 17,000-page tax code, the IRS struggles with questions of compliance. The spot-audits first came to light in the 1980s, when the IRS randomly selected 50,000 taxpayers to identify where and how people would most likely try to cheat on their taxes or where mistakes would most likely be made. The IRS’s desire for information proved unpleasant for those unfortunate taxpayers selected for the program—the study entailed line-by-line audits that left no stone unturned. It reached the point where taxpayers who filed as married were asked to show their marriage licenses and birth certificates were required for anyone claimed as a dependent. Documentation was required for each and every entry on the return.

Public sentiment against the onerous audits ultimately led to congressional concern as well. When the IRS wanted to expand the program to 150,000 audits in 1995, Congress cut the agency’s funding to squelch the program. In recent announcements that the program is being renewed, the IRS has promised to keep intrusions to a minimum for the 50,000 taxpayers involved: the overall number of IRS audits is not to increase, and the number of taxpayers undergoing a complete line-by-line audit is not to exceed 2,000.

Nonetheless, the audits can be a paperwork nightmare. And the agency has modernized their efforts for the 21st century, incorporating innovations such as new software connected to a database of stock trades that goes back 20 years. Imagine the difficulties determining the capital gains on stock from a company that has merged and spun off subsidiaries several times over during the period the stock was owned. With the sell-off prompted by a sluggish economy, many taxpayers are confronting this vexing question. They will find no solace in the tax code, which requires them to wade through the stock’s murky past to arrive at the original value of the stock in order to determine the capital gains.

Rather than invest in new ways to audit a code that is on the brink of collapsing under its own weight, the IRS should embrace efforts to simplify the tax code. A simple, fair, and honest tax code would do far more to improve compliance than another spate of audits. Under the current code, taxpayers spend 6.2 billion hours to comply with the tax code at an annual cost of $194 billion, and the IRS spends roughly $10 billion a year, with around 100,000 employees.

The object of prudent tax policy is to minimize the burden of collecting taxes for both taxpayers and tax collectors. The current tax code violates virtually every principle of tax policy. There is nothing simple about the tax code; compliance costs are substantial, and the degree of uncertainty in the tax code can be vexing for the most scrupulous taxpayer. In fact, the tax code has become so convoluted that 60 percent of individual taxpayers now rely on professional tax preparers. Even the IRS struggles to find the right answers for confused taxpayers. The tax code also fails on the basic question of fairness, with individuals with similar incomes facing widely varying tax rates.

No one likes to pay taxes, and the threat of an IRS audit will send a chill down anyone’s spine. Evaluating compliance will only become more difficult with each year’s new additions to the tax code. Either the IRS will expand to enforce an unfathomable code, or fundamental tax reform can resolve the inequities and confusion built into the current code. Treasury Secretary O’Neill has made clear the need for fundamental tax reform. Unless the Bush administration and Congress address this important issue, taxpayers should resign themselves to a growing IRS presence and a tax code that leaves them vulnerable to intrusive investigations by tax collectors.