Tax Simplification: Just Get Rid of 89 Million Unnecessary Returns
by Jay Starkman, CPA
"The individual income tax is our fiscal beast of burden."
Table 1. 2002 IRS Statistics of Income Summary Estimate of Taxes
Raised by Incomes Not Exceeding the 15 Percent
Tax Bracket (tax dollars in thousands)
The last time the United States really simplified the income tax was in 1872, when the Civil War income tax was repealed. Every tax act since has added complexity. Laws purporting to simplify include new elections, computations, deductions, credits, or phase-ins. Targeted simplification, like simplifying the definition of dependent or the proposed rationalization of the myriad education incentives, merely mop up the mess created by prior tax bills, clearing the deck for future complications.
Recently, there have been two articles proposing real simplification: "100 Million Unnecessary Returns" by Michael Graetz (Yale University)2 and "44 Million Will File Tax Returns But Pay Nothing" by Scott Hodge (the Tax Foundation).3 The IRS receives 130 million Forms 1040 annually. True simplification would reduce tax filings by tens of millions.
Does fairness require that everyone participate in the income tax for the upkeep of government? Even when compliance costs make it uneconomical? How did the income tax become a tax on the masses?
My objectives in this article are to explain the historical reasons that we have no national sales tax and how that contributed to income tax complexity, and to show that real simplification requires exempting a majority of the population from the income tax.
How Income Tax Became a Mass Tax
Initially, the income tax was strictly a revenue measure. Once the Civil War debt was repaid, that revenue was no longer needed, so the 1862-1872 income tax was repealed. For the next 40 years, the government was financed through excises and high tariffs -- consumption taxes.
The poor spent every penny, so they bore a heavy burden of consumption taxes. The wealthy, to the extent they saved or spent funds on services or nonimports, paid a lighter tax as a percentage of income. That made taxation regressive. Adding some progressivity to the nation's tax system was the impetus behind the 1894 income tax. It was a 2 percent tax on incomes exceeding $4,000.
Congress debated whether income tax should be used for progressivity or whether everyone should participate. Rep. William Bourke Cockran of New York, reputed to be the best Democratic orator in the House, made a convincing argument against an income tax targeting only the rich:
In a misguided attempt to balance the budget in 1932, House Speaker John Nance Garner reached agreement with Treasury Secretary Ogden Mills and Ways and Means Committee Chair Charles Crisp to support a 2.25 percent national sales tax on everything except food and cheaper clothing. Almost every national political leader from the president to the leaders of both houses of Congress supported the sales tax. So did Bernard Baruch and William Randolph Hearst. To disguise the nature of the tax, it would be called a "manufacturer's tax."
Led by Reps. Fiorello LaGuardia, who later became mayor of New York City, and Robert Doughton, who later became chair of the Ways and Means Committee, members rebelled against their House leaders. The tax was opposed by the American Federation of Labor, four farm groups, retailers, and wholesalers. There were mass meetings throughout the country to protest the tax. It was overwhelmingly defeated.
There was a general feeling that sales tax was the domain of the states, and that the federal government should not endeavor to enact a sales tax because it would compete with the states' ability to raise revenue. To cover the revenue shortfall, the Revenue Act of 1932 boosted income tax and estate tax rates.
In a lame duck session in December 1932, President Herbert Hoover again asked Congress to enact the sales tax and Garner promised to allow the bill to reach the House floor. Thereupon, President-elect Franklin Delano Roosevelt announced that he opposed a federal sales tax. From his experience as New York's governor, Roosevelt decided it was best that federal and state governments not levy taxes on the same source and that a general sales tax should be the exclusive domain of the states. The federal sales tax proposal was dead.6
World War II brought not only high rates but decreases in the personal exemption. Wage withholding was introduced to avoid a collection nightmare. The income tax was transformed from an elite tax to a mass tax. Why?
The personal exemption was significantly lowered in 1940 and again in 1941 as part of a "preparedness" campaign. The Roosevelt administration in 1942 contemplated financing for World War II through higher income tax rates. Republicans proposed an alternative: A sales tax for the purpose of having those with low incomes contribute to the treasury. Had Roosevelt not opposed a federal sales tax, we would have one today. Instead, Treasury Secretary Henry Morgenthau made a counterproposal to lower the personal exemption to $624. It was uneconomical to have income tax reach such small incomes, but it was sold as a compromise to defeat the sales tax initiative.7
Table 2. Personal Exemption 1913-1969
The personal exemption reached a nadir of $500 in 1944, but that was enacted in conjunction with a new standard deduction and with an increase in the dependent exemption. Those 1944 changes dropped 12 million low-income people from the tax rolls. The Roosevelt administration recognized that collecting $161 million from taxpayers near the bottom endangered collection of $17 billion from 50 million other taxpayers.8
President Harry Truman cited fear of inflation and later financing for the Korean War as reasons for not lowering rates or raising exemptions. There was some modest relief in 1947, when rates were lowered slightly and the personal exemption was raised to $600.
President Dwight Eisenhower made overhaul of the Internal Revenue Code in 1954 the centerpiece of his tax policy. Its major individual tax policy was recodification of the World War II tax policy, making low-income individuals liable for income tax. Eisenhower echoed 19th century philosophy when he threatened to veto any bill that included an increase in exemptions, declaring:
Alternate methods were created to supplement the personal exemption. The standard deduction, introduced as a 10 percent deduction ($1,000 maximum) from adjusted gross income in 1944, was converted into a fixed deduction after 1976. The refundable earned income tax credit is essentially a subsidy on the minimum wage. The child tax credit is a proxy for an increased dependent exemption and partial relief from FICA/Self-Employment tax.
The exemptions and standard deduction excused about half of all families from tax after World War II. Inflation, rising real incomes, bracket creep, and failure to adequately increase the exemption have now made the income tax almost universal. Median income for a family of four in 1948 was $3,468. With a $2,400 exemption and $347 standard deduction, only $721 was taxable (if they didn't itemize) -- just 20 percent of income was subject to tax. In 2001 that family earned $63,278 and, after $11,600 of exemptions and a $7,600 standard deduction, $44,078 was taxable -- 70 percent subject to tax. Today's tax reaches income levels far below those deemed fair or efficient under Roosevelt or Truman, and we're taxing a huge chunk of it for relatively little revenue!10
The Government Accountability Office singles out fraudulent EITC as a "high-risk" area. The IRS estimates that deliberate and inadvertent EITC noncompliance cost between $8.5 billion and $9.9 billion in 1999.11 As soon as an EITC-eligible individual gets his W-2 "refund ticket," he rushes to the tax preparer and the IRS receives a return in January. W-2s needn't be filed with the Social Security Administration (SSA) until February 28 (March 31 if filed electronically) and a 30-day extension is available. There is some further delay as the SSA processes and finally shares the information with the IRS. Except when security procedures have stopped a refund from being issued, it's only long after refunds have been cashed that the IRS can begin determining whether EITC refunds were proper. Protecting against fraudulent EITC diverts tremendous IRS resources that could quite profitably be directed toward high-income taxpayer compliance.
The EITC has fueled the growth of the commercial tax preparation industry. Few low-wage earners take advantage of the EITC advance payment process (Form W-5), so most have a large refund due at year- end. They are often in desperate need of money, and commercial preparers have developed sophisticated marketing presentations to sell those taxpayers refund anticipation loans with electronic filing. The refund which arrives three weeks earlier than it otherwise would costs those poor taxpayers 100 percent to 400 percent per annum interest.
The EITC and the child credit turn a simple tax return into one that is very complex. Unintelligible statutes force people to seek professional help. Can anyone translate or justify the following gobbledygook:
Some praise the Tax Reform Act of 1986 (TRA 86) as the model for a broad-based, revenue-neutral, low rate, efficient, and equitable tax system. As a tax return preparer, I found that it brought horrible complexity by dividing income into baskets of active income, passive income, and portfolio income. It introduced new discrepancies between book income and taxable income, and additional categories of alternative minimum taxable income. It added complex phaseouts of the benefit of the 15 percent bracket, itemized deductions, and personal exemptions. As it eliminated garden-variety real estate tax shelters, it added low-income housing credits, bringing a whole new generation of tax shelter promotion.
The real simplification in TRA 86 was elimination of preferential tax treatment for capital gains. But Congress was so confident that the repeal would be temporary that it failed to repeal the code sections distinguishing between long-term and short-term capital gains. The IRS was also skeptical and retained separate sections on Schedule D for tracking long-term and short-term capital transactions.
While tax rates have risen from the 28 percent TRA 86 rate, capital gains and dividend rates have been halved. The result is that some investment income is now taxed at a maximum 15 percent rate. Never before has this nation inverted taxation to favor the wealthy investment class over the working middle class. Even Richard Nixon gave a preference to wages with a maximum rate of 50 percent while other income was taxed at 70 percent.
In Bryan's time, tariffs made taxation regressive. Today it's Social Security taxes. The intergenerational promise of Social Security is financed through a tax on wage income under $90,000. Benefits are skewed so that those earning at the higher end toward $90,000 finance those earning at the lower end toward $3,000.
Fairness requires a review of the regressivity of FICA and self- employment taxes when considered in combination with the income tax. FICA began as a 2 percent levy. Today, it's a combined 15.3 percent on employees and employers. The government calculates a "reserve fund," the difference between cumulative receipts and benefits, but the reserve is used for current government spending. The mythical "reserve" cannot hide the regressive nature of a payroll tax whose surplus makes the federal budget deficit look much smaller.
A self-employed family that struggles to maintain a lower- middle-class lifestyle on $40,000 of income may owe no income tax, but pays nearly $6,000 in self-employment tax. For most people, the 15.3 percent burden on earned income far exceeds their income tax. What logic justifies a combined 30.3 percent marginal tax rate on those earning up to $60,000 annually, while higher incomes are taxed at a maximum of 35 percent, or 15 percent when income consists of capital gains and dividends? From a rate perspective, our tax on income has become regressive.14 (The January 1, 2013 Obama tax increases and ObamaCare 3.8 percent tax on gross income significantly raised taxes on capital gain and dividends to almost 25 percent for high earners, but makes a very strange progressivity curve between earned income and unearned income.)
Randolph Paul asserted that fairness in U.S. income taxation has been designed around ability to pay and rate progressivity. Conscious design should take advantage of the fact that lower-income individuals spend almost all of their income on consumption while higher-income individuals are the source for most savings and investment. That dichotomy between the consuming and saving segments provides an opportunity to simplify the income tax.
A consumption tax will reach all lower-income earnings, while an income tax is the only tax that will reach higher-income earnings. We don't need an income tax, certainly not a complex one, to tax the majority with lower incomes. Bryan's "insignia of freemen" alluded to consumption taxes in the form of tariffs and excises.
To collect $72 billion from the lower 68 percent, there are alternatives that don't require a tax return. How much is $72 billion? It's an 8 percent flat income withholding tax at source on the 68 percent. Or it's the equivalent of raising tax rates on the 32 percent by just 2 percent, but not as simple as exempting the first $60,000 of income. That 32 percent also pays tax on income below $60,000. I'm not advocating any particular method. Rather, I am merely demonstrating that a replacement for $72 billion in revenue is easily within reach.15
Rep. John Linder, R-Ga., proposed a regressive tax insidiously called the FairTax in 2003. It's a 30 percent national sales tax [23% according to supporters. Though a $100 item with 30% sales tax costs $130, that's 23% "tax inclusive:" $130-($130 x 23%) = $100. Thus $30 tax added to a $100 purchase is a 23% tax!] could replace income, payroll, estate and gift taxes. The practical effect would dramatically lower the tax on the wealthy and raise it on the poor and middle classes. The simple fact is that the majority spends everything they earn and would be fully taxed, while the wealthy could avoid the tax by saving, or spending abroad.16 Today, FairTax is still pending legislation going nowhere, sponsored by Rep. Rob Woodall (R-GA) and Sen. Saxby Chambliss (R-GA).
Michael Graetz proposes a new federal value added tax at a 10 percent to 15 percent rate, a $100,000 family income tax exemption ($50,000 single), and a 25 percent income tax for those above the $100,000 threshold. He claims that his proposal would reduce tax return filings by 80 percent to 90 percent. Failing that, Graetz proposes repeal of the regular tax because by 2008, the AMT will produce more revenue than the regular tax while requiring filing of 40 million fewer tax returns. That would bring far more simplification and fairness than the Linder tax and introduce a major new revenue source. It might also be an invitation to a far higher tax burden that could more simply be generated through the existing income tax mechanism.17
The income tax is one of the most flexible and useful taxes. It can be used as a weapon against inflation or to redistribute wealth. Adjusting rates and the taxable base at the high end influences savings and investment. Those same adjustments at the low end influence consumption. It has been overused to effect social and economic policies, another proof of its utility. No other single tax serves so many functions.
The revenue stream from the income tax is sufficiently reliable, without inducing inflation, to leverage debt. It was the revenue stream from income taxes that enabled the United States to finance the Civil War, World War I, and World War II, and convinced lenders that our government was creditworthy so that it could borrow many times the tax base. That still holds true today.
There will be fierce opposition to reducing participation in the income tax. Many will promote the old argument of William Bourke Cockran that the poor must participate in every tax the government imposes or lose the right of participation. The tax preparation industry will oppose, arguing that the current system works. (No, it's broken. That's why we have a tax reform commission.) The real estate industry will predict a collapse. Charities will predict a humanitarian disaster. Insurance companies are already squawking that they might lose half their products without tax incentives. A friend at the IRS volunteer income tax assistance program argued with me that the poor shouldn't be deprived of participation in the income tax.
The wealthy will oppose being singled out for income tax. The poor will fear loss of the EITC (even if unfounded). Most arguments will be speculative. Congress will fear loss of influence as the majority of the population loses immediate concern for an income tax that no longer reaches them. (Not to mention the effect on campaign fundraising.)
The benefits from concentrating on just the 32 percent of the population that yields the substantial revenue on which our nation depends includes reduced compliance costs. That would save consumers and businesses billions of dollars annually. Much complexity stems from arranging fairness for the majority 68 percent. Reducing income tax filings by 89 million would vastly simplify the IRS computer modernization program, the second high-risk area identified by the GAO.
We could simplify tax calculations. It has become increasingly difficult to manually verify a computer tax calculation. There are three interacting baskets of income: (1) regular income tax at 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent, (2) alternative minimum income tax at 26 percent and 28 percent, and (3) capital gains tax at 5 percent, 15 percent, 25 percent, and 28 percent on net long-term capital gains in excess of net short-term capital losses, interacting with the ordinary rates and the AMT, plus all the phaseouts. Those calculations precede the tax credits and additional taxes that must also be computed to arrive at the proper tax liability.
Twenty-five years ago I would review returns for missed deductions or elections or failure to use income averaging. Today the big errors are often buried in complex computer calculations of AMT adjustments that few preparers manually verify. Those errors are as likely to favor the government as the taxpayer.
In making its individual income tax recommendations, the tax reform commission should (1) drop the filing requirement for tens of millions of unnecessary tax returns, (2) reduce and restrict the nonrevenue functions of the IRS, (3) rationalize the tax burden we place on the spending class and the incentives we provide to the saving class, and (4) improve progressivity of our tax structure.
Graetz correctly points out that "[t]he fundamental problem is that the IRS is being asked to do too much." Getting the IRS to do less involves dramatically reducing the number of tax returns that are filed. The tax reform commission will fail if it does not get rid of unnecessary returns by whatever means it decides to propose. Simplifying taxes is easy. Just get rid of 89 million unnecessary income tax returns.
1 Randolph E. Paul, Taxation for Prosperity (Indianapolis: Bobs-Merrill Company, 1947), p. 261. Paul was a prominent tax lawyer, founder of Paul, Weiss, Rifkind, Wharton, and Garrison, and author of many tax books, including coauthoring the original Mertens Law of Federal Income Taxation. He was Treasury general counsel during World War II and was the one who turned the income tax into a mass tax. See http://www.taxhistory.org/thp/readings.nsf/ .
2 Michael Graetz, "100 Million Unnecessary Returns: A Fresh Start for the U.S. Tax System," 112 Yale Law Journal 261 (November 2002).
3 Scott Hodge, "44 Million Will File Tax Returns But Pay Nothing," Tax Foundation's Tax Features, March/April 2004, p. 1. Updated article at http://www.taxfoundation.org/publications/show/542.html.
4 William Bourke Cockran. 53-2 Cong. Rec. vol. 26, Appendix, pp. 462-469 (Jan. 30, 1894) at 464-465.
5 William Jennings Bryan. 53-2 Cong. Rec. vol. 26, pp. 1655-1658 (Jan. 30, 1894) at 1656.
6 Jordan A. Schwarz, "John Nance Garner and the Sales Tax Rebellion of 1932," Journal of Southern History, May 1964, pp. 162-180. Garner's poor handling of the sales tax issue is one reason Roosevelt defeated him for the 1932 Democratic presidential nomination. Garner had to settle for vice president.
7 Randolph Paul, Taxation in the United States (Boston: Little, Brown, and Company, 1954), pp. 326-349. Paul wrote that a comprehensive study on a federal retail sales tax was inserted into the printed record of the Ways and Means Committee hearings in July 1943. I have not checked the Congressional Record, but the following memo may be the study he was referring to: "Considerations Respecting a Federal Retail Sales Tax," Staff Memo, Division of Tax Research, U.S. Treasury Department, Aug. 26, 1943, reproduced at http://www.taxhistory.org/Civilization/Documents/ Sales/HST29010/sales.htm.
8 Paul, supra note 1, at 149-154, 186.
9 John F. Witte, The Politics and Development of the Federal Income Tax (Madison, WI: University of Wisconsin Press, 1985), pp. 147-148.
10 U.S. Census Bureau, "Historical Income Tables -- Table F-8. Size of Family by Median and Mean Income: 1947 to 2001, Families With Four People," see http://www.census.gov/hhes/income/histinc/f08.html.
11 "High-Risk Series, an Update," U.S. Government Accountability Office, GAO-05-207 (January 2005), pp. 37- 38; "Internal Revenue Service, Recommendations to Improve Financial Operational Management," U.S. General Accounting Office, GAO-01-42 (November 2000); "Internal Revenue Service, Status of Recommendations From Financial Audits and Related Financial Management Reports," U.S. Government Accountability Office, GAO- 05-393 (April 2005), p. 21.
12 Janet Spragens and Nancy Abramowitz, "Low-Income Taxpayers and the Modernized IRS: A View From the Trenches," Tax Notes, June 13, 2005, p. 1407; Alan Berube, Anne Kim, Benjamin Forman, and Megan Burns, "The Price of Paying Taxes: How Tax Preparation and Refund Loan Fees Erode the Benefits of the EITC," the Brookings Institution and Progressive Policy Institute Survey Series (May 2002); see "Low Income Taxpayer Protection Act of 2005," H.R. 894 (2005), section 4(a)(1)(B), or search at http://thomas.loc.gov.
13 "Tax Loans: Quick Cash, Steep Price," Atlanta Journal-Constitution, April 3, 2005, p. D1; David Cay Johnston, "Tax Credit Is Financial Bonanza for 2 Big Tax Preparers," New York Times, May 21, 2002, p. C1.
14 EITC and other welfare programs offset much regressivity for low-income taxpayers. For a full discussion of this complex subject, see C. Eugene Steuerle and Jon M. Bakija, Retooling Social Security for the 21st Century, Right & Wrong Approaches to Reform (Washington, D.C.: Urban Institute Press, 1994).
15 Taxable income in 2002 totaled $4.1 trillion. Replacing $72 billion lost from exempting almost $900 billion of taxable income of the 68 percent majority requires raising rates on the 32 percent that remain by just 2 percent. The same $72 billion could be raised with an 8 percent flat withholding tax on lower incomes.
16 Linder has coauthored The Fair Tax Book: Saying Goodbye to the Income Tax and the IRS, with radio talk show host Neal Boortz. Though he wrote this book on tax policy, Boortz seems never to have heard of Tax Analysts before reading that he's been awarded "this year's prize for Worst Idea in a Serious Public Policy Debate." This ignorant tax book is a bestseller. http://www.taxhistory.org, click on "Readings in Tax History," then "Fair Tax, Bad Tax" (May 26, 2005).
17 Graetz, supra note 2. Sheryl Stratton, "Tax Lawyers Critique Graetz Reform Plan at Judicial Conference," Tax Notes, May 2, 2005, p. 560.
END OF FOOTNOTES
Jay Starkman is a sole practitioner in Atlanta. This article was originally published in Tax Notes, August 15, 2005. (c)2005 Tax Analysts.
Created: August 23, 2005; Last updated: March 25, 2013