One Avenue to Bipartisan Tax Reform: Simplification and Improved Tax Administration

There are many ways to restructure the tax code. Elected officials often fail to detect opportunity when they adhere in a path-dependent way to one past model of success, such the 1986 tax reform.  An alternative approach where even the acclaimed 1986 effort made at best modest progress would focus on making tax code simpler for taxpayers and improving compliance without adding to IRS costs. This reframing of reform stands a chance of stepping around the partisan wrangling that deters progress on so many other policy fronts.

In recent weeks, IRS Commissioner John Koskinen has been lamenting the Service’s inability to perform its functions well, mostly recently at today’s Tax Policy Center event on the impact of IRS budget cuts. It not only continues to lose staff, but less experienced staff quickly must replace a large fraction of senior employees who are leaving.

At the same time, congressional Republicans have been finding fault with much of what the IRS does, from its inability to regulate the activities of social welfare 501(c)(4) organizations to its implementation of the Affordable Care Act. Democrats say the solution is a bigger IRS budget. Republicans say it is a smaller one. But there is an alternative choice.

Focus tax reform on an objective almost never before given priority: developing a system that is less costly for taxpayers to comply with, mostly through simplification of existing laws. Simultaneously modify laws where IRS enforcement is difficult or impossible or too costly ever to do well. Such an effort would not necessarily require base broadening, though that often would be consistent. For instance, rather than engaging in a non-productive debate over whether to  eliminate or expand  refundable tax credits for low-income households, Congress  could simply replace the existing credits with versions that are easier for taxpayers to understand and for the IRS to administer.

Put everything on the table, ranging from business deductions to multiple capital gains tax rates to complexity of retirement plan options to refundable credits that go mainly to the poor. Include many of the small items like mileage deductions that can be vastly simplified.

The first step in such an effort would be for the IRS to better understand known error rates for each preference and “program” based partly upon the audit data it keeps. Believe it or not, the agency has never done any good comprehensive study on this, though on occasion it has tried to measure the extent of noncompliance in rough terms.

And the IRS has never conducted this type of research to inform policy, as opposed to allocating internal audit functions. IRS should study taxpayer time costs, error rates, causes of error, costs of auditing, and administrative aspects of every program put into the tax code. For instance, although relatively easy to do, it has never really distinguished in its studies what it can’t know or can’t enforce well from the error rates that it can find under some audit technique.

The second step would be for the IRS and its colleagues at the Treasury’s Office of Tax Policy to be prepared, at least in a tax reform setting, to acknowledge what provisions it cannot monitor at a reasonable cost. For instance, it can estimate compliance with wages reported to the IRS on W-2 forms, but it seems fairly certain that it has little idea of how much charitable contributions of clothing are overvalued. Even if it did, it has no way to efficiently allocate resources to monitor such deductions.

I recognize that a balancing act is required, since IRS doesn’t want to encourage even more noncompliance. But an agency can’t engage in continuous improvement if it doesn’t study and acknowledge its problems in the first place. Indeed, some of IRS’s recent public conflicts, such as over the tax-exempt status of Tea Party and other social welfare organizations, stemmed from what every tax policy analyst has always known: that limited resources devoted to vague or hard-to-enforce law eventually can lead to disaster.

With attention to individual simplification, along with the improved compliance that comes from removal of laws that can’t be enforced, both parties could claim a victory. A simpler and more efficient tax system conforms to both progressive and conservative principles.

Unlike more money for audit, moreover, making the system more administrable and simpler modestly increases national well-being.

In a fairly comprehensive study I undertook for the American Bar Association and the American Institute of Certified Accountants many years ago, I  found that expanding IRS audit resources was likely to raise more than was spent, ranging from $2 to $7, depending upon type of return, for every dollar spent. I doubt the conclusion has changed greatly since then. But while more auditors would help redistribute the tax burden in favor of compliant taxpayers, there’s no gain and a likely loss in output by taking workers away from more productive activities.

Administrative reform and simplification, on the other hand, can reduce noncompliance while increasing the time that taxpayers can devote to more productive pursuits. Of course, to achieve this goal, leaders of both parties have to cooperate to make changes that benefit the public, even when it gives them no partisan advantage.

This column originally appeared on TaxVox.

The President’s Capital Gains Proposals: An Opening for Business Tax Reform?

In his budget proposal, President Obama would raise capital gains taxes as a way to finance middle class tax relief. Along with many Republicans, he also supports tax rate cuts for business and efforts to prevent multinational corporations from avoiding U. S. taxation.

This raises an intriguing possibility. Why not pay for at least some corporate tax cuts with higher taxes on individuals on their receipts of capital gains or similar returns? In effect, as it becomes increasingly difficult to find a workable way to tax profits of the largest businesses, largely multinational companies, why not tax shareholders directly?

Most proposals to deal with the complexities of international taxation wrestle with how to tax corporations based on their geographical location. But as Martin Sullivan of Tax Notes said years ago, what does it mean to base taxes on a company’s easily-reassigned mailing address when its products are produced, consumed, researched, and administered in many places?

By contrast, individuals usually do maintain residence primarily in one country. Thus, reducing corporate taxes while increasing shareholder taxes on U.S. residents largely avoids this residence problem. Indeed, many proposals, such as a recent one by Eric Toder and Alan Viard, move in this direction. While such a tradeoff is not a perfect solution, it makes the taxation of the wealthy easier to administer and less prone to today’s corporate shelter games.

Many have made the case for why cutting corporate rates is sound policy. On what policy grounds can Obama’s plan for raising taxes on capital gains fit into this story?

Much of the publicity about taxing the rich focuses on their individual tax rate. But many very wealthy people avoid paying individual taxes on their capital income simply by never selling stock, real estate, or other assets on which they have accrued gains. That’s because, at death, the law forgives all capital gains taxes on unsold assets.

The very wealthy, moreover, tend to realize a fairly small share of their accrued gains and an even smaller share than those who are merely wealthy. It makes sense: the nouveaux riche seldom become wealthy unless they continually reinvest their earnings. And when they want to consume more, they can do so through means other than selling assets, such as borrowing.

Warren Buffett was famous for claiming that he paid lower tax rates than his secretary, alluding in part to his capital gains rate versus her ordinary tax rate on salary. But Buffett doesn’t just pay a modest capital gains tax rate (it was 15 percent when he made his claim and about 25 percent now). On his total economic income, including unrealized gains, it’s doubtful that his personal taxes add up to more than 5 percent.

At the same time, many of the wealthy do pay significant tax in other ways. If they own stock, they effectively bear some share of the burden of the corporate tax. Real estate taxes can also be significant and not merely reflect services received by local governments. Decades ago I found that more tax was collected on capital income through the corporate tax than the personal tax. Today, the story is more complicated, since many domestic businesses have converted to partnerships and Subchapter S corporations, where partners and shareholders pay individual income tax on profits.

The President would raise the capital gains rate and tax accrued gains at death. This would encourage taxpayers to recognize gains earlier, since waiting until death would no longer eliminate taxation on gains unrealized until then. The proposal would effectively capture hundreds of billions of dollars of untaxed gains that forever escape taxation under current law.

Trading a lower corporate tax rate for higher taxes on capital gains could also result in a more progressive tax system since many corporate shares sit in retirement plans and charitable endowments. It would reduce to hold onto assets—in tax parlance, lock-in—and the incentive to engage in tax sheltering. There’s also a potential one-time gain in productivity, to the extent that the proposal taxes some past gains earned but untaxed, as such taxes would have less effect on future behavior than the taxation of current and future returns from business.

Tough issues would remain. Real reform almost always means winners and losers. For instance, how would a proposal deal with higher capital gains taxes for non-corporate partners and owners of real estate? Toder and Viard, for instance, would apply higher individual taxes only on owners of publicly-traded companies.

Still, some increase in capital gains taxes could help finance corporate tax reform without reducing the net taxes on the wealthy. It is exactly the type of real world trade-off that both Democrats and Republicans must consider if they are serious about corporate tax reform.

This column originally appeared on TaxVox.

President Obama’s Middle-Class Tax Message in the State of the Union

President Obama’s tax proposals for the middle class were a key element of his State of the Union address. But they represent only relatively modest efforts to create subsidies through the tax code rather than through other departments of government. Looked at broadly, many only tinker around the edges of tax policy and count on an overloaded and troubled agency, the IRS, to administer them.

Will $320 billion of tax increases finance very much?

The President proposes $320 billion in tax increases on the wealthy. It sounds like a lot. But how much would it finance in expenditures and additional tax breaks, assuming it is all spent rather than used to reduce the deficit?   Well, there are approximately 320 million Americans, so the proposal would garner about $1,000 per person. But, then again, the $320 billion would be raised over ten years, so that’s about $100 per person per year that could be financed.

Now compare the $100 per year with what we already spend. Add together federal, state, and local spending plus tax subsidies (and the President would “spend” a good deal of his additional revenue on new tax subsidies), and the figure comes out to more than $20,000 per person.  And that spending is scheduled to rise by an average of several thousand dollars per year over the same ten year period, due more to (hoped for) economic growth than anything else.

None of these observations speaks for or against the proposals. I like some of them, don’t like others. But if you want to have a significant impact on the budget and on the well-being of citizens, concentrate on where the money is.

Should we throw even more subsidies into the tax code?

Like almost all his recent predecessors, the President talks in his State of the Union address about tax simplification, but in almost the same breath he proposes a range of new tax subsidies. It’s an old story. Tax cuts show up as “smaller” government to those who simply count up net government revenue as a measure of government size. According to that theory, we could achieve dramatically limited government or no government at all if we put all expenditures into the tax code, thereby collecting negative taxes on people, at least as long as we run deficits.

Huge jurisdictional problems also lead to more and more being put into the tax code. Discretionary spending is capped; tax subsidies are not. Congressional tax committees can use increased revenues to pay for increased tax subsidies, but they do not have the jurisdictional authority to spend additional tax revenues on higher levels of spending, or, on the flip side, to reduce many items of direct spending to pay for lower tax rates.

Now I’m not suggesting that a new tax subsidy is necessarily more complex than a new expenditure. But it does raise the issue of whether the IRS is the right agency to administer the subsidy. All of this is coming at a time when the IRS has lost significant resources, the Taxpayer Advocate suggests we should be ready for a horrible filing season in which taxpayers will have difficulty getting ahold of someone in IRS to advise them, and many in the IRS remain disheartened and have been pushed into a bunker mentality that fears bad publicity more than bad administration.

This column originally appeared on TaxVox.