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TAX REFORM. PROBLEMS WITH THE INCOME TAX SYSTEM. The system is too complex The system is difficult to enforce The system is unfair The system provides incentives to do things simply to avoid taxation that are bad for the economy. COMPLEXITY.
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PROBLEMS WITH THE INCOME TAX SYSTEM • The system is too complex • The system is difficult to enforce • The system is unfair • The system provides incentives to do things simply to avoid taxation that are bad for the economy
COMPLEXITY • In 2001 persons and businesses spent 12 cents on administrative record keeping for every dollar collected in taxes. (testimony of J.Scott Moody before the House Ways and Means committee) • Number of words in the Internal Revenue Code keeps growing
Enforcement Difficulties • $ 5.1billion/yr on enforcement activity • About 1% of individual income tax returns are audited • non-wage sources of income are difficult to match with reports • business expenses and income are difficult to verify, even with an audit • Under-reporting is extensive. Based on audits, IRS estimate in 2001 was that income was under-reported by 16% (This does not include unreported income from illegal activity.)
The system is unfair • What’s Fair? • Horizontal Equity: people who are otherwise identical ought to pay the same taxes When do two people have the same ability to pay taxes? Does marital status make a difference? How about family size? Occupational choice? • Vertical Equity: people with greater ability to pay taxes should pay more. How much more?
Share of Capital Income in total Income of Highest .5% in Income Distribution
Are Tax Rates Too High? The Laffer Curve • “It seems difficult for some to understand that high rates of taxation do not necessarily mean large revenue to the government, and that more revenue may often be obtained by lower rates….The most outstanding recent example of this principle is the sales policy of the Ford Motor company. Does anyone question that Mr. Ford has made more money by reducing the price of his car …than he would have made by maintaining a high price….the price is too high to the large taxpayer and he is avoiding a taxable income by the many ways that are available to him.” ” Andrew W. Mellon, “Taxation: The People’s Business,” Macmillan, New York, 1924
The System Distorts Incentives Not all sources of income are taxed:Examples Employer paid fringe benefits are increasing as a percentage of total compensation Employees have had an incentive to buy comprehensive health insurance through their employers even though such insurance has a high administrative cost/dollar of coverage Implicit rents on owner-occupied housing are not taxed. The net worth of most Americans is heavily concentrated in the value of their homes.
Tax Expenditures and the Shrinking Tax Base • Andrew Mellon on the availability of tax-exempt investment opportunities, said “The idle man (who can invest in tax-exempt securities is relieved; the producer (who invests in taxable activities) is penalized….(and) we destroy the initiative in which the whole country should share, and which is the source of revenue to the government.” • “ …there is going to be a taxpayer revolt in this country…Now the revolt is not going to come from the poor. They do not pay very much in taxes. The revolt is going to come from those people with incomes from $7,000 to $20,000 who pay every nickel of taxes at the going rate. They do not have the loopholes and gimmicks to resort to, Mr. Chairman. However, when these people see, as I see, that in the year 1967, there were 155 tax returns in this country with incomes over $200,000 and 21 returns with incomes over a million dollars for the year on which the ‘taxpayers’ paid the U.S. Government not 1 cent of income taxes , I think those people are going to say it is time to do something about it and I concur.” Treasury Secretary Barr before Congress, 1969
Tax Expenditures, Tax Revenues, and Outlays as aPercentage of GDP, FY1974-2005
What’s Wrong with the Current System According to the 2005 Presidential Advisory Commission • • We have lost sight of the fact that the fundamental purpose of our tax system is to raise revenues to fund government. • • Tax provisions favoring one activity over another or providing targeted tax benefits to a limited number of taxpayers create complexity and instability, impose large compliance costs, and can lead to an inefficient use of resources. A rational system would favor a broad tax base, providing special treatment only where it can be persuasively demonstrated that the effect of a deduction, exclusion, or credit justifies higher taxes paid by all taxpayers. • • The current tax system distorts the economic decisions of families and businesses, leading to an inefficient allocation of resources and hindering economic growth. • • The complexity of our tax code breeds a perception of unfairness and creates opportunities for manipulation of the rules to reduce tax. The profound lack of transparency means that individuals and businesses cannot easily understand their own tax obligations or be confident that others are paying their fair share. • • The tax system is both unstable and unpredictable. Frequent changes in the tax code, which often add to or undo previous policies, as well as the enactment of temporary provisions, result in uncertainty for businesses and families. This volatility is harmful to the economy and creates additional compliance costs.
The Solution? • Tax Expenditures produce complexity. • Tax Expenditures erode the tax base and necessitate higher tax rates on what is taxed in order to raise the same revenue. • Tax expenditures benefit some at the expense of others. • Tax expenditures induce people to make choices to reduce their tax bills that they would not otherwise make. • Bottom Line: No reform is possible without a reduction of Tax Expenditures.
Looking Ahead • More Tax Revenue is Needed • More Savings Are needed Look for proposals for a consumption based value added tax • Reduced Consumption of Carbon-based fuels is needed Look for Carbon Tax proposals
