National Taxpayer Advocate Nina E. Olson today released her annual report to Congress, identifying the need for tax reform as the number one priority in tax administration. The Advocate expressed continuing concern that the IRS’s increasing use of hard-core enforcement actions, particularly tax liens, is inflicting unnecessary harm on financially struggling taxpayers. The report also examines challenges the IRS is facing in implementing the new health care law.
“There has been near universal agreement for years that the tax code is broken and needs to be fixed,” Olson said in releasing the report. “Yet no broad-based attempt to reform the tax code has been made. This report documents the burdens the tax code imposes on taxpayers and explores why many taxpayers may nevertheless feel wedded to key aspects of the current system, undermining efforts at reform.”
Compliance Burdens. A TAS analysis of IRS data shows that taxpayers and businesses spend 6.1 billion hours a year complying with tax-filing requirements. “If tax compliance were an industry, it would be one of the largest in the United States,” the report says. “To consume 6.1 billion hours, the ‘tax industry’ requires the equivalent of more than three million full-time workers.”
Individual taxpayers find return preparation so overwhelming that about 60 percent now pay preparers to do it for them. An additional 29 percent use tax software, with leading software packages costing $50 or more. IRS researchers recently estimated that the annual monetary tax compliance burden of the median individual taxpayer (as measured by income) is $258.
Tax Reform Challenges and Public Awareness. The report discusses why efforts at tax reform – which usually focus on eliminating tax breaks in exchange for lower rates – have not succeeded. “It is sometimes suggested that taxpayers are looking for a free lunch – that they want to see lower tax rates but keep their tax breaks and retain their government benefits, all while balancing the budget,” Olson said. “But this perspective overlooks the fact that federal tax and spending policies are complex, and most people don’t have the time to study these policies in detail. Our aim is to improve public knowledge of the trade-offs involved and to help policymakers and the taxpaying public conduct a more informed conversation about tax reform alternatives.”
The report attempts to improve awareness of the extent to which taxpayers benefit from tax breaks by discussing the subject in detail. The report attempts to improve awareness of the connection between taxation and spending by recommending that the government provide all taxpayers with a “taxpayer receipt” each year that presents a breakdown showing how their federal dollars are spent.
“The Special Interests Are Us.” The report notes there is a widespread belief that the influence of entrenched “special interests” is the biggest roadblock to comprehensive tax reform. “There is no doubt that many provisions in the tax code benefit narrow groups of taxpayers,” the report says. “But the dirty little secret is that the largest special interests are us – the vast majority of U.S. taxpayers. Virtually all of us benefit from certain exclusions from income, deductions from income, or tax credits.”
These tax breaks (known as “tax expenditures”) now total $1.1 trillion a year. Among the largest are the exclusion of employer contributions for health care, the exclusion for retirement plan contributions and earnings, the mortgage interest deduction, reduced tax rates for dividends and capital gains, exclusions for Medicare benefits, the earned income tax credit, and the deduction for state and local taxes. Other popular benefits include the child and dependent care credits; the deductions for charitable donations and contributions to traditional IRAs; and exclusions for distributions from Roth IRAs, for distributions from Section 529 education savings plans, for contributions to Flexible Spending Accounts (both medical and dependent care), and for public transportation subsidies.
Tax Breaks Reduce Average Tax Liability by About $8,000 Per Return. A TAS analysis found that, on average, the tax liability of each individual who files a federal tax return is reduced by about $8,000 a year due to these tax breaks. Moreover, since tax is computed as a percentage of income, a taxpayer who pays a 25 percent tax rate could be benefiting from deductions or exclusions from income worth $32,000. The report presents an example of a fairly typical taxpayer who faces a 25 percent marginal tax rate on his “taxable income,” yet ends up paying an average tax rate of 9 percent on his “gross income” because of tax breaks.
“If tax rates are to be substantially lowered, many existing tax breaks will have to be eliminated immediately and others will be phased out,” Olson said. “But I believe most taxpayers will conclude this is a worthwhile trade-off. If tax reform proceeds on a revenue-neutral basis, the average taxpayer’s liability will not change, and we will end up with a tax system that is simpler, more transparent, and easier and cheaper for taxpayers to navigate.”
The report acknowledges that Congress may at some point raise tax revenues to address the nation’s long-term fiscal challenges. However, the report suggests that Congress first enact structural tax reform on a revenue-neutral basis and keep separate the decision whether to adjust tax rates.
“Zero-Based Budgeting” Approach Recommended. The report recommends that Congress approach tax reform in a manner similar to zero-based budgeting. The starting assumption should be that all tax breaks would be eliminated; a tax break would then be retained only if a compelling case can be made that the benefits of providing the tax break outweigh the complexity burdens it creates. The report suggests additional core principles for tax reform and summarizes key simplification proposals the Advocate’s office has made in past reports, including repealing the Alternative Minimum Tax for individuals and consolidating the number of incentives that encourage taxpayers to save for education and retirement.
Tax Reform Suggestion Box. The National Taxpayer Advocate is today launching a web page to solicit taxpayer suggestions regarding tax reform. “What would taxpayers be willing to give up if they knew that others are giving up their breaks and the end result would be a much simpler system?” Olson asked. “What particular provisions of the existing tax system are especially burdensome or seem particularly unfair?” Suggestions may be submitted at http://www.TaxpayerAdvocate.irs.gov. TAS will track suggestions and post results periodically.
To read the full report click here.