The trouble with 'simplifying' taxes
Every few years, American politicians vow to fix the tax code - to simplify it, reform it, or abolish it altogether. In Congress, they push through their "tax amendment to end all tax amendments." Feeling morally vindicated, they castigate the Internal Revenue Service as the source of all confusion. At reporting time, Americans find themselves entangled in a new web of accounting rules, reporting requirements, instructions, schedules, and worksheets. Unable to disentangle themselves through the more "customer friendly" IRS, they turn to American politicians, who begin the process anew.
Now, conforming to this ritual, the Bush administration has vowed to fix the tax code - to simplify it, reform it, or abolish it altogether. Before entering the path of political circularity, it should pause and reconsider what has caused all the confusion. It is not the IRS, but the politicians themselves. How have they contributed to tax complexity, and how can the problem be fixed?
First, since the present tax code was instituted in 1913, legislators have transformed it from a fiscal instrument to a tool of social and economic policy. Accompanying this metamorphosis has been a host of new exclusions, deductions, credits, and accounting methods. Thus, for example, the current code offers a US production activities deduction; special write-offs for small businesses; retirement, education, and medical savings accounts; and tax credits for child care, rehabilitating historic structures, and hiring ex-felons.
While advancing meritorious policy goals, such provisions lengthen compliance time and increase the cost of doing business. Reversing the trend requires a fundamental reassessment of statutory purpose. Should the tax code serve to influence investment decisions or reengineer society? Or should it purport to promote tax neutrality and equitably distribute the tax burden?
Second, legislators have periodically granted tax concessions to narrow constituencies and special-interest groups. These concessions have riddled the general law with countless exceptions, exceptions-to-the-exceptions, conditions, and provisos. For example, to accommodate real estate interests, Congress carved out a rental exception to the passive activity loss rules. Bowing to shipbuilder demands, it exempted income earned under naval contracts from normal percentage-of-completion accounting. Catering to US banking interests, it exempted from the antideferral regime income derived by a foreign subsidiary in a financing business.
Such measures not only subsidize activities that may be unprofitable, but also add to the complexity of convoluted provisions. Undoing these effects may require closed-rule legislation based on bipartisan consensus and a commitment to statutory uniformity.
Third, since the mid-1970s, Congress has tied tax rates and schedules to short term fluctuations in projected budget deficits. This linkage, complicated by politics and legislative procedure, has saddled simple rules with onerous phase-ins, phase-outs, effective dates, and sunset provisions.
Thus, for example, in 2005 estates are taxed at a maximum rate of 47 percent. This rate falls to 46 percent in 2006, then 45 percent in 2007 to 2009. The estate tax completely disappears in 2010. The following year, it miraculously reappears at a rate of 55 percent, absent further action by Congress to make the repeal permanent. Such lack of uniformity makes tax planning a nightmare for the average citizen. Fixing the problem requires steady rates, consistent tax treatment, and procedural rules designed to achieve both.
Finally, legislators have enacted provisions on a piecemeal basis, without adequately considering their relationship to other sections of the tax code. This shortsightedness has resulted in striking inconsistencies in statutory definition, application, and operation.
For example, "control" has one meaning for stock redemption purposes, another meaning for corporate reorganization purposes, and yet another meaning for foreign corporate ownership purposes. Under Section 954, income is "highly taxed" if assessed at 90 percent of the top marginal rate for corporations; under Section 904, the test is 100 percent of the top marginal rate for any person. Excess foreign tax credits may be carried back one year, then forward as many as 10 years; excess net operating losses, back two years, then forward up to 20 years; excess net capital losses, back three years, then forward up to five years.
Inconsistencies such as these garnish complexity with incoherence. Simplification requires that Congress analyze the degree to which proposed legislation comports with existing provisions, and the manner in which such legislation might impact their operation.
Ultimately, tax reform begins and ends with politicians. Paradoxically, they are both the source of the problem and the solution.
• Richard J. Joseph teaches federal income taxation at the University of Texas at Austin and is author of 'The Origins of the American Income Tax.'