This year’s $1.35 trillion tax cut reduced incometax rates and modestly liberalized the tax rules forretirement saving plans. However, the new tax lawdid not slow the progression of the tax code towardincreasing levels of complexity. In fact, the law made441 changes to the tax code and created a compli-cated series of phase-in periods for tax changes.Meanwhile, the congressional Joint Committee onTaxation released a 1,300-page study cataloging theexcessive complexity of federal taxes but providingonly limited proposals for reform.Minor simplification reforms will not beenough. The tax system is caught in a spiral ofcontinual change and nonstop growth in rules.Since the mid-1980s there have been 7,000 feder-al tax code changes and a 74 percent increase inthe number of pages of tax rules. Complyingwith federal tax requirements wastes 6 billionhours each year as families and businesses fillout tax forms, keep records, and learn tax rules.The key factor that causes rising income taxcomplexity is that the tax base is inherently diffi-cult to measure. The Haig-Simons measure ofincome favored by many academic theorists iseconomically damaging and too impractical touse in the real world. As a result, policymakershave fallen back on ad hoc and inconsistent rulesto define the income tax base. That intensifiescomplexity and creates instability as policymak-ers gyrate between different definitions of the taxbase. In addition, the lack of a consistentlydefined tax base increases the use of the tax codefor special-interest tax breaks, thus furtheradding to the system’s complexity.The complexity and inefficiency of the indi-vidual and corporate income taxes have led togreat interest in replacing them with a consump-tion-based tax. The leading consumption-basedtax proposals, including the national retail salestax and the Hall-Rabushka flat tax, could dra-matically simplify federal taxation. Those tax sys-tems would eliminate many of the most complexaspects of federal taxation, including deprecia-tion accounting and capital gains taxation.Imposing the largest federal tax on incomewas a historic mistake: no simple, efficient, andstable measure of income has been found in ninedecades of the income tax. It is time to recognizethis mistake and replace the income tax with aconsumption-based alternative.
Simplifying Federal Taxes
The Advantages of Consumption-Based Taxation
by Chris Edwards
_____________________________________________________________________________________________________
ChrisEdwardsisdirector of fiscal policy studiesat the Cato Institute.
Executive Summary
No. 416October 17, 2001
Introduction
At the beginning of the 20th century, fed-eral taxes accounted for about 3 percent ofthe nation’s gross domestic product, and theentire tax code and related regulations filled just a few hundred pages. Today, federal taxesaccount for 21 percent of GDP, and federaltax rules span 45,662 pages.
1
Each year Americans spend 6.1 billionhours—more than 3 million person-years—on tax compliance activities, such as fillingout tax forms, keeping records, and learningtax rules.
2
The complexity of the tax systemhas spawned a huge public and private “taxindustry” to perform administrative, plan-ning, avoidance, and enforcement activities.Those activities represent a pure loss to theeconomy since they consume resources andhuman effort that could otherwise be used tocreate useful goods and services. In addition,tax complexity leads to inequitable treatmentof citizens, causes high error rates, promotesevasion, and impedes economic decision-making by creating uncertainty.The chief source of federal tax complexityis the income tax on individuals and corpo-rations. Two-thirds of Americans think theincome tax system is “too complex.”
3
Treasury Secretary Paul O’Neill called thesystem an “abomination.”
4
In 1976 presi-dent-to-be Jimmy Carter called for “a com-plete overhaul of our income tax system. Ifeel it’s a disgrace to the human race.”
5
SinceCarter’s attack, the number of pages of feder-al tax rules has doubled.
6
In 1988 Princeton professor DavidBradford, a former deputy assistant secretaryin the Department of the Treasury, notedthat “recent experience confirms the tenden-cy of an income tax . . . to evolve toward evergreater complexity.”
7
Another decade of expe-rience has underscored this reality. Therehave been 1,916 changes to the tax code inthe past five years and 7,000 changes since1986.
8
This year’s tax cut law creates 441 sep-arate tax code changes.
9
The good news is that this is a problemabout which policymakers can do some-thing. Congress has taken a few small stepsto raise the visibility of the tax complexityproblem, most recently with the release of a1,300-page report from the Joint Committeeon Taxation.
10
The study cataloged the exces-sive complexity of federal taxes and proposedmore than 100 specific reforms. However,most of the proposals were quite narrow andlimited in scope, as required by the commit-tee’s mandate.
11
Limited simplifications will not beenough. Substantial reform can come onlyfrom uprooting the income tax system andreplacing it with a consumption-based sys-tem, such as the Hall-Rabushka flat tax, anational retail sales tax, or a consumed-income tax.
12
Switching to a consumption-based tax holds the promise of spurringgreater economic growth and vastly simplify-ing the federal tax system.This study examines the magnitude offederal tax complexity, the costs created bythat complexity, the problems inherent intaxing “income,” the simplification advan-tages of consumption-based taxes, and somelong-term economic trends affecting the taxsystem.
The Magnitude of FederalTax Complexity
The Growth of Federal Tax Rules
A century ago the federal governmentrelied on excise taxes and customs duties for91 percent of its revenue. As the governmentgrew and sought new sources of revenue, itenacted the corporate income tax in 1909with a 1 percent rate and the individualincome tax in 1913 with rates ranging from 1to 7 percent.
13
The income tax began with just 16 pages of tax laws, and the entire fed-eral tax system still had only 500 pages oflaws and regulations in the late 1930s.
14
World War II launched the income tax on atrajectory of continual growth, fueled byemployer withholding begun in 1943.
2
Switching to aconsumption-based tax holdsthe promise ofspurring greatereconomic growthand vastly simpli-fying the federaltax system.
Today, total federal tax rules span 45,662pages, having more than doubled in lengthsince the 1970s (Figure 1). This page countincludes the full tax code, tax regulations, andsummaries of various Internal Revenue Servicepronouncements such as letter rulings andtechnical advice memoranda.
15
The tax codeitself runs at least 1.4 million words and hasincreased in length 51 percent since 1985.
16
The growth in tax complexity can also bediscerned from other statistics, as summa-rized in Table 1. For example, the number ofdifferent tax forms produced by the IRSincreased 23 percent in the past decade from402 to 496.
17
Taxpayer phone calls to the IRSdoubled during the 1990s from 56 million to111 million, even though the number of tax-payers grew only 12 percent.
18
Apparently,the growth in usage of home computer taxsoftware, and the 1.5 billion annual hits tothe IRS Web page, have not reduced taxpayerconfusion.
19
The Tax Industry
The complexity of the tax system hasspawned a huge “tax industry” engaged intax filing, administrative, planning, avoid-ance, enforcement, and other activities. Themost visible part of the tax industry is theIRS with a budget of $9 billion in fiscal 2001.The IRS employs 97,000 people and usesabout 74,000 volunteers each year duringtax-filing season.
20
In addition, there areabout 24,000 tax workers in other federalagencies.
21
The complexity of the income tax hasoverwhelmed federal tax workers. Year afteryear the IRS answers a large proportion oftaxpayer phone queries incorrectly. The mostrecent government investigation found thatIRS workers provided incorrect answers totaxpayer questions 47 percent of the time.
22
Alongside the federal tax bureaucracy, ahuge private tax industry of accountants,lawyers, and other workers has developed. Ofthe 1.6 million accountants in the country,perhaps 30 percent, or 480,000, are in taxpractice.
23
Of the 1,048,000 attorneys in thecountry, perhaps 10 percent, or 105,000, arein tax practice.
24
Enrolled agents are anothergroup of tax specialists and number at least35,000.
25
There are also uncounted thou-sands of computer specialists, administrativepersonnel, and others in the tax industry, aswell as tens of thousands of tax workers instate and local governments.
26
3
Today, total fed-eral tax rulesspan 45,662pages, havingmore than dou-bled in lengthsince the 1970s.
14,00016,50019,50026,30040,5004005048,20045,662-5,00010,00015,00020,00025,00030,00035,00040,00045,00050,000
191319391945195419691974198419952001
Figure 1Total Pages of Federal Tax Rules (tax code, tax regulations, various IRS rulings)
Source: CCH, Inc.,
Standard Federal Tax Reporter,
2001.
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Simplifying Federal Taxes: The Advantages of Consumption-Based Taxation, Cato Policy Analysis No. 416
Executive Summary
This year's $1.35 trillion tax cut reduced income
tax rates and modestly liberalized the tax rules for
retirement saving plans. However, the new tax law
did not slow the progression of the tax code… (More)
This year's $1.35 trillion tax cut reduced income
tax rates and modestly liberalized the tax rules for
retirement saving plans. However, the new tax law
did not slow the progression of the tax code… (More)
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