Fairer Tax System: Reduce Complexity and Increase Compliance

In this presidential election year the arguments for a tax system that is fair have reemerged.  The term fair is subjective and although there is no agreement on which tax structure would be the fairest, most would agree that it should be transparent, efficient, and simple.    One dimension of fairness that addresses these criteria is the complexity of tax laws.  Two hundred years ago James Madison, the fourth president of the U. S. reiterated this complexity conundrum:

“… if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood…or undergo such incessant changes that no man who knows what the law is today can guess what it will be tomorrow.”

Studies have shown that reducing complexity--for filing, paying, and reporting--will increase compliance rates resulting in increased government revenues.  We want to maximize compliance rates without increasing the burden to comply and decrease tax evasion without adding to the administration costs.  In trying to improve tax fairness by satisfying economic, distributional or other policy goals, the political process adds complexity by adding exemptions and reduced tax rates.  The assumption is that to offset this loss in revenue statutory rates are increased and taxpayers that do comply bear the burden of paying a greater percentage of taxes and this affects fairness.   

The complexity of the current U. S. tax system is enormous.  In 1995 the federal tax laws had 40,500 pages and in 2006, total pages were 66,498.  It has over one hundred special tax provisions, phase-in and phase-out rules, and a parallel tax system--alternative minimum tax.  Businesses may pay up to five different types of taxes: profit, social, property, turnover, and other taxes for example municipal fees and fuel taxes.  This complexity adds a cost burden to compliance and according to IRS estimates, compliance costs are $140 billion per year.   Governments are reluctant to reduce business tax burdens because they fear decreased revenues but results from studies conducted by the World Bank indicate that countries that reformed their system increased investment and economic growth which increased their tax revenues.

Complexity and non-compliance contribute to the tax gap, the difference between taxes that are owed and what is actually paid.   Illegal tax evasion by the cash sector, Schedule C filers has the lowest compliance rates.  The estimated tax gap for 2001 is $345 billion and as of 2006 $55 billion of this was recovered.  The Internal Revenue Service estimates that underreporting is about 50% for this sector and the annual underground economy is estimated to be between one to three trillion dollars.  Tax avoidance, cheating, has become pervasive.

Complex tax systems in trying to address fairness have imposed different tax treatment on people with the same income and can lead to multiple interpretations of the same tax laws and this creates the opportunities for tax avoidance, non-compliance.  Compliance rates between the non-cash and cash sector create disproportionate payments of taxes.  Empirical studies support the theory that compliance decreases when people believe that others are evading taxes.  In 2008, congressional investigators found that over a ten year period, payments of federal payroll taxes withheld were short by $58 billion.  Over the past ten years payroll taxes that were withheld but not submitted doubled.    

There is growing political support to simplify the tax codes and reduce non-compliance.    It would appear that the simplest tax system would be a flat tax but no country has been successful at administering a flat tax.  Economists in Estonia, a former communist state in Eastern Europe who had implemented flat taxes, are promoting a change to a progressive system of taxation because of the social disparities caused by the flat tax.  Some other countries claiming to have a flat tax, such as Hong Kong in reality have a steeply progressive tax system.

 Another suggestion is to adopt a value added tax, (VAT).  Value added tax is one consumption tax that has been studied by the Government Accountability Office.  After studying five countries that were chosen for their range and complexity of VAT systems-- Australia, Canada, France, New Zealand and the United Kingdom– they concluded that VATs required significant resources in order to maintain compliance even in simple systems.  Administering a VAT system would not reduce complexity and compliance risks because both the U. S. system and VATs use tax preferences and exemptions to further complicate the tax laws.  VATs may be easier to enforce but both systems can be manipulated, face compliance and burden challenges, and are subject to evasion.   

The conclusion based on studies and analysts demonstrates that making the tax system simpler, with fewer special provisions, does increase compliance rates and reduces the tax burden.  Broadening the tax base can mitigate the affects of high tax rates and increase government revenues.  Technically we could create a fairer tax system by reducing tax complexity and non-compliance and make it fair, transparent, efficient, and simple.  Making these changes appears to be difficult due to conflict with political goals and the propensity to avoid taxes.  Implementing a system that meets these criteria requires political and taxpayer commitment.

General Tax Rates for Select Countries*  

General Sales Tax

Country

Corporate
Taxes

Individual
Taxes

Payroll
Taxes

Value Added
Tax (VAT)

General Service
Tax (GST)

Sales
Tax

United States

Federal

15-39%

0-35%

15.30%

-

-

-

State

0-12%

0-10.3%

-

-

-

0-10.25%

Australia

30%

0-45%

-

-

10%

-

Canada

Federal

29.5-35.5%

15-29%

-

-

5%

-

Provincial

-

4-17.95%

-

-

-

0-10%

Estonia

22%

22%

33.90%

18%

-

-

France

33.30%

10-50%

45%

19.6%
(5.5% on food)

-

-

Hong Kong

16.50%

0-15%

 -

-

 -

-

New Zealand

30%

0-39%

- 

-

12.50%

-

United Kingdom

21-28%

0,20,40%

23.80%

17.50%

-

-

* Does not compare social benefits received.

.