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Increase Tax Compliance with a Practical Tax Code January 30, 2007

Posted by federalist in Taxation.
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There are two ways that taxes can be unfair:

  1. We could argue that taxes are unfair to the degree that they are levied disproportionately to the ability of individuals to bear them, or to the degree that the costs and benefits of tax revenue are asymmetric.  [I will address this in a future essay.]
  2. The tax system is also unfair if it does not enforce compliance evenly across the individuals subject to it — i.e., if some people get away without paying their “fair share,” while others — either altruistically, or due to selective enforcement — comply more fully.

The problem with a complex tax regime like we have in the United States is that the complexity itself practically guarantees unfairness on both counts.  Today the WSJ Editorial Board addresses the second problem, “The ‘Tax Gap’ Myth“:

The “tax gap” is the difference between what the Internal Revenue Service thinks taxpayers should be paying and what it collects. The IRS currently estimates this at about $290 billion a year.

To put the tax gap in perspective, consider that the IRS took in tax receipts in fiscal 2005 of more than $2.2 trillion and that the overall U.S. tax compliance rate is about 85%. … Nina Olson, the IRS’s taxpayer advocate, told Congress last year that IRS auditors have found that an estimated 94% of noncompliance is the result of honest mistakes by tax filers who simply don’t understand the 17,000-page beast of a tax code.

Not surprisingly, the key to a more fair tax system is simplification: making it easier to understand and comply.

All voluntary tax compliance systems have their limits. Under today’s tax code, the only way the feds can raise compliance is to place extraordinary burdens on taxpayers. Most of those financial and social costs also end up being borne by those who already dutifully pay their taxes, in the name of catching the few who evade the law. The tradeoff for higher tax collection is less liberty, as we learned only a decade ago when Congress held much-hyped hearings on abusive IRS tactics and audits.

There is a better way. The more complicated a tax system, the more likely taxpayers won’t understand, or will try to dodge, the rules. Simple tax regimes, such as a single flat rate, encourage compliance and efficiency, not to mention economic growth. This has been the experience of many Eastern European countries after they imposed a flat tax, and the U.S. had similar jumps in reported tax income from “the rich” following the 1986 tax reform that cut rates and closed loopholes.

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