Tax Reform Principles Part 3: Simplicity and Administration

This is the the third and final article reviewing the general principles to consider when reforming a tax system. The first principle evaluated how the tax system encourages economic growth. The second addressed fairness. This article will review concepts of simplicity and administration.

There are three points to consider in the area of simplicity and administration.

• How costly is it for taxpayers to determine their tax liability and pay their taxes?
• Can the system be easily administered by the government and does it encourage taxpayers to comply with the filing requirements?
• Are some individuals able to avoid their legal liabilities?

Without question, the tax code has become exceptionally complex. As someone who has been a practicing CPA for over 25 years, I can attest to the growing complexity of tax law and difficulty of compliance. The complexity is good business for people who make a living from tax planning and preparation, but there is certainly a cost to taxpayers. Even a person or family of modest means and little financial complexity often finds it challenging to prepare their own taxes. The plethora of possible deductions and credits, that often have very specific qualification, can be challenging to understand and apply. Thankfully there are a number of inexpensive software providers that can help, but if you don't correctly answer the questions or input something incorrectly, you can easily make an error. There have been many bills passed over the past 30+ years that were touted as tax simplification, which resulted in a more complex tax system. Deciding whether the cost of compliance is overly burdensome is a subjective matter, but there definitely is a cost and be wary when Congress promises more simplification.

The U.S. tax system is based upon voluntary compliance. This puts the primary burden upon taxpayers to timely file and properly report their income and corresponding tax liabilities. Timely filing is relatively easy. You simply have to file and pay your taxes by the requisite due date. Properly calculating the tax liability can be more difficult to ascertain. As explained above, the complexity of the tax code makes it extremely challenging to calculate the correct tax. Although few people will avoid filing returns because of the complexity, the burdens of compliance can result in people failing to report certain items because it's unlikely to be discovered by the IRS. With regards to government administration, the number of fraudulent returns that have been filed over the past few years is an indication of the difficulties the IRS has processing and administering tax returns correctly. One recent example highlights their ineffectiveness. A few years ago, several hundred fraudulent tax refunds adding up to several million dollars were mailed to the same overseas address without any questions raised by the IRS until after the checks were cashed. While it's entirely possible a a common mailing address may be used, good internal controls should have identified the number of refunds being mailed to the same address as a potential problem.

On the third point, it's important to remember that tax avoidance is perfectly legal, but tax evasion is not. Avoidance involves structuring your affairs in a manner to minimize your tax liability. Part of tax complexity is a result of years of successful tax planning that Congress and the IRS deemed inappropriate, which resulted in new laws and regulations designed to close the "loopholes". Tax evasion can range from a person who is paid in cash to avoid paying taxes to wealthy individuals who fail to report millions of dollars held in overseas financial institutions. While you may have an opinion on the severity of the crime, a willful failure to report income is illegal whether it's $100 in cash you got paid to work for someone or you have $100 million parked overseas. As technology improves, so has the ability of the IRS to identify potential fraud. The IRS has also dramatically increased certain penalties for failing to comply as an additional incentive to follow the rules. However, the basic premise of voluntary compliance ultimately means some people will be able to successfully avoid paying their taxes.

How would you evaluate the simplicity and administrative effectiveness of the U.S. tax code?