Taming the Tax Code

“Every tax ought to be so contrived as both to take out and keep out of the pockets of the people as little as possible, over and above what it brings into the public treasury.”

-Adam Smith, The Wealth of Nations, 1776

Tax policy is critical to every modern government; not only do taxes provide the resources for government spending, but also the structure of taxation can have significant impacts on a nation’s economic performance. By global standards, the United States has one of the most complex tax codes in the world. The tax code has become a political tool rather than simply a means of funding the government. As the code has grown in complexity, it has become a significant drag on the economy. In a world economy where many nations are lowering marginal tax rates, the complexity and costs of taxation in the United States are fast becoming a burden on international competitiveness and economic output. As Congress prepares to vote on a permanent repeal of the Death Tax, policymakers should acknowledge that this would only be a first step toward much-needed fundamental tax refrom.

The growth of government has seen a similar expansion in revenues, which reached a peacetime high of 20.8 percent of GDP in 2000. As the search for revenues increased, so, too, did the pursuit of tax breaks and loopholes to avoid the heavy burden of taxation. As accountants and tax lawyers sought to keep their clients one step ahead of the tax collector, the tax code has become so riddled with court rulings, tax credits, tax loopholes, and obfuscated definitions of income that it is not likely that any one person can truly understand its entirety.

Unfortunately, complexity comes at a price. First it creates a “fiscal illusion,” which makes it difficult for taxpayers to actually understand the tax burden or make reasonable decisions about the size of government. As noted by Professor Roger Congleton of George Mason University, the higher the costs of becoming informed about the tax code and fiscal policy, the more people will choose to remain ignorant about the actual outcomes of fiscal policy . Fundamentally, this means that as the tax code becomes more complex, the outcome of fiscal policy becomes more difficult to assess and the potential for political manipulation increases.

In addition, complexity increases the costs of administering the tax code. Far from holding true to Adam Smith’s eloquent plea for simplicity, the current U.S. tax code has been estimated by the Tax Foundation to cost taxpayers $194 billion in compliance costs in 2002. In other words, for every dollar of revenue that goes to fund government spending, taxpayers pay a compliance surcharge of 20 cents just to help the government collect taxes.

Complexity does more than just increase compliance costs. It increases the deadweight costs in the economy as resources are diverted from productive to less valued uses. This includes resources that are paid to accountants and lawyers to decipher the tax code as well as the more significant costs of lobbyists and campaign spending as various interests pursue favorable changes to the tax code. Quite simply, the tax code has become an awkward, inefficient political tool for redistributing income to favored policy goals. Tax credits, tax breaks, earned income credits, and deductions are used to promote everything from renewable energy to family values. Far from simply collecting the revenue to fund federal spending, the tax code has become a favored target of lobbyists and others seeking special benefits or social goals.

The proliferation of tax laws has effected individuals and businesses alike. Because it is not indexed for inflation, the Alternative Minimum Tax (AMT) is reaching lower and lower income groups who now find themselves calculating their taxes twice—once in the traditional format and then again under the AMT—before filing their taxes. Middle income earners in the United States now face four to six marginal tax rates for the same income, depending on their particular situation. For corporations, things are even more complex. Compliance has become so costly that, according to Chiara Bronchi and Richard Herd of the OECD, “costs are perhaps as high as half the yield of the tax due to the cost of the professionals needed to ensure compliance, to minimize payments, and to apply the different rules off financial and tax accounting.”

Clearly, any sense of rationality in the U.S. tax code has fallen by the wayside. Fundamental reform is urgently needed. For years, Congress has fiddled while the code burned. Each Congress leaves behind a stratum of new complications in the tax code that frustrate taxpayers and raise the cost of doing business in America. Corporations have reached the point where reorganizing overseas is a serious option. Adam Smith identified the basics of any tax code more than 200 years ago: A simple, fair system that minimizes compliance and administrative costs. The U.S. tax code has become embroiled in special interest politics and social policy. At this point, it would be better to start from scratch, designing a tax code to ease the collection burden while forcing the lobbyists and interests groups to pursue their interests elsewhere.