Tax Policy
Summary of Estimates of the Costs of the Federal Tax System Gao ID: GAO-05-878 August 26, 2005In 2005, Americans will pay about $2.1 trillion in combined federal taxes, including income, payroll, and excise taxes, or about 16.8 percent of Gross Domestic Product (GDP). However, the amount of taxes paid does not reflect the total cost to taxpayers of the federal tax system. In addition to taxes paid, taxpayers also bear compliance costs and efficiency costs. Understanding the magnitude of these additional costs is important because every dollar spent on compliance and lost due to inefficiency represents a dollar that society could have spent for other purposes. In response to a congressional request for information on the magnitude of the compliance and efficiency costs of the current federal tax system, this study describes the nature of these costs, presents the difficulties associated with estimating them, and summarizes existing estimates of their magnitude. GAO did not make independent estimates of compliance or efficiency costs nor did we replicate any of the studies. GAO is not making any recommendations in this report.
Complying with the federal tax system costs taxpayers time and money. Estimating total compliance costs is difficult because neither the government nor taxpayers maintain regular accounts of these costs and federal tax requirements often overlap with recordkeeping and reporting that taxpayers do for other purposes. Although available estimates are uncertain, taken together, they suggest that total compliance costs are large. For example, combining the lowest available estimates for the personal and corporate income tax yields a total of $107 billion (roughly 1 percent of GDP) per year. As noted, whether this is a definitive lower bound for compliance costs is uncertain. The tax system also results in economic efficiency costs because tax rules cause individuals to change their behavior in ways that ultimately leave them with lower-valued combinations of consumption and leisure than they would have obtained if the tax system did not affect their behavior. Estimating efficiency costs is very challenging because the tax system has such extensive and diverse effects on behavior. In fact, we found no comprehensive estimates of the efficiency costs of the current federal tax system. The two most comprehensive studies we found suggest that these costs are large--on the order of magnitude of 2 to 5 percent of GDP each year (as of the mid-1990s). However, the actual efficiency costs of the current tax system may not fall within this range because of uncertainty surrounding taxpayers' behavioral responses, changes in the tax code and the economy since the mid-1990s, and the fact that the two studies did not cover the full scope of efficiency costs. The goal of tax policy is not to eliminate compliance and efficiency costs. The goal of tax policy is to design a tax system that produces the desired amount of revenue and balances the minimization of these costs with other objectives, such as equity, transparency, and administrability. In addition, whether compliance and efficiency costs could be reduced by redesigning the tax system and, if so, by how much would depend critically upon the detailed characteristics of the new tax system.
GAO-05-878, Tax Policy: Summary of Estimates of the Costs of the Federal Tax System
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Report to Congressional Requesters:
August 2005:
Tax Policy:
Summary of Estimates of the Costs of the Federal Tax System:
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-05-878]:
GAO Highlights:
Highlights of GAO-05-878, a report to House Majority Leader Thomas
DeLay, and the Honorable John Linder, House of Representatives:
Why GAO Did This Study:
In 2005, Americans will pay about $2.1 trillion in combined federal
taxes, including income, payroll, and excise taxes, or about 16.8
percent of Gross Domestic Product (GDP). However, the amount of taxes
paid does not reflect the total cost to taxpayers of the federal tax
system. In addition to taxes paid, taxpayers also bear compliance costs
and efficiency costs. Understanding the magnitude of these additional
costs is important because every dollar spent on compliance and lost
due to inefficiency represents a dollar that society could have spent
for other purposes.
In response to a congressional request for information on the magnitude
of the compliance and efficiency costs of the current federal tax
system, this study describes the nature of these costs, presents the
difficulties associated with estimating them, and summarizes existing
estimates of their magnitude. GAO did not make independent estimates of
compliance or efficiency costs nor did we replicate any of the studies.
GAO is not making any recommendations in this report.
What GAO Found:
Complying with the federal tax system costs taxpayers time and money.
Estimating total compliance costs is difficult because neither the
government nor taxpayers maintain regular accounts of these costs and
federal tax requirements often overlap with recordkeeping and reporting
that taxpayers do for other purposes. Although available estimates are
uncertain, taken together, they suggest that total compliance costs are
large. For example, combining the lowest available estimates for the
personal and corporate income tax yields a total of $107 billion
(roughly 1 percent of GDP) per year. As noted, whether this is a
definitive lower bound for compliance costs is uncertain.
The tax system also results in economic efficiency costs because tax
rules cause individuals to change their behavior in ways that
ultimately leave them with lower-valued combinations of consumption and
leisure than they would have obtained if the tax system did not affect
their behavior. Estimating efficiency costs is very challenging because
the tax system has such extensive and diverse effects on behavior. In
fact, we found no comprehensive estimates of the efficiency costs of
the current federal tax system. The two most comprehensive studies we
found suggest that these costs are large”on the order of magnitude of 2
to 5 percent of GDP each year (as of the mid-1990s). However, the
actual efficiency costs of the current tax system may not fall within
this range because of uncertainty surrounding taxpayers‘ behavioral
responses, changes in the tax code and the economy since the mid-1990s,
and the fact that the two studies did not cover the full scope of
efficiency costs.
The goal of tax policy is not to eliminate compliance and efficiency
costs. The goal of tax policy is to design a tax system that produces
the desired amount of revenue and balances the minimization of these
costs with other objectives, such as equity, transparency, and
administrability. In addition, whether compliance and efficiency costs
could be reduced by redesigning the tax system and, if so, by how much
would depend critically upon the detailed characteristics of the new
tax system.
Components of the Total Cost of a Tax to Taxpayers:
[See PDF for image]
[End of figure]
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[End of section]
Contents:
Letter:
Results in Brief:
Background:
Estimates of Tax Compliance Costs Are Uncertain Because Taxpayers
Generally Do Not Record Them; However, Total Costs Are Likely to Be
Large:
Efficiency Costs Arising from Tax-Induced Changes in Behavior Are
Likely to Be Large but Can Only Be Modeled with Considerable
Uncertainty:
Agency Comments and Our Evaluation:
Bibliography:
Tables:
Table 1: Features of the Tax System as of July 2005:
Table 2: Available Estimates of Tax Compliance Costs for Individual
Taxpayers (Including Self-employed):
Table 3: Available Estimates of Tax Compliance Costs for Corporations
and Partnerships:
Table 4: Estimates of the Efficiency Gains from the Removal of Selected
Distortions in the Current Tax System:
Figures:
Figure 1: Components of the Total Cost of a Tax to Taxpayers:
Figure 2: Compliance Burden Is One Cost Taxpayers Face in Complying
with the Tax System:
Figure 3: Efficiency Costs Are One Cost Taxpayers Face in Complying
with the Tax System:
Letter August 26, 2005:
The Honorable Thomas DeLay Majority Leader:
House of Representatives:
The Honorable John Linder:
House of Representatives:
In 2005, Americans will pay about $2.1 trillion in combined federal
taxes, including income, payroll, and excise taxes, or about 16.8
percent of Gross Domestic Product (GDP). These taxes fund the services
provided by government. As taxpayers, we balance the costs of taxes
with the benefits of government.
However, the amount of tax revenue collected does not reflect the total
cost to taxpayers of the federal tax system. In addition to taxes paid,
taxpayers also bear compliance costs and efficiency costs. Compliance
costs include the value of the taxpayer's time and resources, along
with any out-of-pocket costs to paid tax preparers and other tax
advisors, spent to ensure compliance with the tax laws. Efficiency
costs result when taxes alter the economic decisions that people make-
-decisions such as how much to work, how much to save, what to consume,
and where to invest--in ways that reduce overall well-being.
Understanding the magnitude of these additional costs is important,
because every dollar spent on compliance and lost due to inefficiency
represents a dollar that society could have spent for other purposes.
Moreover, these costs could change if policymakers decide that the
projected imbalances between federal revenues and expenditures can only
be addressed by changes to both sides of the fiscal system.
Despite the existence of these costs and their size, the goal of tax
policy is not to eliminate compliance and efficiency costs. The goal of
tax policy is to design a tax system that produces the desired amount
of revenue and balances the minimization of compliance and efficiency
costs with other objectives, such as equity, transparency, and
administrability.
In response to your May 17, 2004, letter to the Comptroller General and
follow-up meetings with your staffs, this report summarizes what is
known from the academic literature about the current tax system's
compliance and efficiency costs. For both costs this report describes
their nature, presents the difficulties associated with estimating
them, and summarizes existing estimates of their magnitude.
To describe the nature of compliance costs and the difficulty in
estimating their magnitude, we reviewed the relevant economic
literature. To summarize the relevant cost estimates available from the
literature we reviewed studies that present original, empirically based
compliance cost estimates. We report on all studies that we found that
estimate the compliance costs to individuals or businesses attributable
to the current (post-1986) tax system. We did not make independent
estimates of compliance costs nor did we replicate any of the studies.
To describe the nature of efficiency costs and the difficulty in
estimating their magnitude, we reviewed the relevant economic
literature. To summarize the relevant cost estimates available from the
literature, we reviewed 1,567 abstracts from peer-reviewed journal
articles and books (dating back to January 1986) and nonacademic
research organization publications and economic working papers (dating
back to January 1, 2000) that contained some reference to taxes, costs,
and efficiency. On the basis of reading the abstract or paper, we
excluded studies that did not produce original empirical estimates or
that made estimates for the federal tax system existing prior to the
major 1986 tax reform. We found no study that comprehensively estimated
the cost of all behavioral distortions caused by the tax system. We
also consulted with experts outside of GAO, asking them if they were
aware of studies we overlooked. We report on all studies that we found
that estimate the efficiency costs attributable to selected aspects of
the current system. The coauthor of one of these studies is a key
contributor to this report. To ensure the objectivity and independence
of this product, a second economist, within GAO, verified that the work
in this section was presented in an accurate and unbiased manner. We
also report on a set of studies that estimate efficiency gains that
would result from replacing the current federal tax system with an
alternative system that raised the same amount of revenue. As was the
case with compliance costs, we did not make independent estimates of
efficiency costs nor did we replicate any of the studies.
We conducted our work in Washington, D.C., from November 2004 through
July 2005 in accordance with generally accepted government auditing
standards. We provided a draft of this report in August 2005 to the
Commissioner of Internal Revenue. We received technical comments via e-
mail from the IRS Office of Research. Where appropriate, we made
changes in our report in response to these comments.
GAO is making no recommendations in this report.
Results in Brief:
The federal tax system imposes a wide range of recordkeeping,
computational, and filing requirements upon businesses and individuals.
Complying with these requirements costs taxpayers' time and money.
Neither the government nor taxpayers maintain regular accounts of these
costs and many important elements of the costs are difficult to measure
because, among other things, federal tax requirements often overlap
with recordkeeping and reporting that taxpayers do for other purposes.
Available estimates of aggregate compliance costs vary in terms of the
scope of costs that they include, the tax years that are represented,
assumptions regarding the monetary value of an hour of time spent on
tax compliance, and other methodological factors. Although the
Information Collection Budget for the Department of the Treasury
contains the most comprehensive estimate, analysts both within Treasury
and outside consider this estimate to be very uncertain because it is
based on survey data from the early 1980s that have been updated each
year with an overly simplified methodology. The Internal Revenue
Service (IRS) is in the middle of a long-term research effort to
improve its methodology for estimating compliance burden. Preliminary,
partial results from that new effort and evidence from other
researchers indicate that compliance costs are large, even though the
total remains uncertain. For example, combining the lowest available
(and incomplete) estimates of individual and corporate compliance cost
yields a total of $107 billion (roughly 1 percent of GDP) per year;
however, other studies estimate costs 1.5 times as large. Whether
compliance costs could be reduced by redesigning the tax system and, if
so, by how much would depend upon the details of the new tax system,
since all tax systems have compliance costs.
The tax system also results in economic efficiency costs. These costs
occur when tax rules cause individuals to change their work, savings,
consumption, and investment behavior in ways that ultimately leave them
with a combination of consumption and leisure (now and in the future)
that they value less than the combination they would have obtained
under a tax system that did not alter their behavior. Some of the
incentives to change behavior are intentionally designed into the tax
system, others are unintended consequences of rules designed to achieve
other objectives, such as equity or increased revenue yields.
Estimating efficiency costs is very challenging because federal taxes
have such extensive and diverse effects on behavior. In fact, we found
no comprehensive estimates of the efficiency costs of the current
federal tax system. Nonetheless, we did find some studies that estimate
the efficiency costs attributable to selected aspects of that system.
Although none of these studies, either individually or in the
aggregate, provide a basis for estimating the total efficiency cost of
the tax system, they do indicate that those total costs are likely to
be large. The two most comprehensive studies we found show costs on the
order of magnitude of 2 to 5 percent of GDP each year (as of the mid-
1990s). However, the actual efficiency costs of the current tax system
may not fall within this range because of uncertainty surrounding
taxpayers' behavioral responses; changes in the tax code and the
economy since the mid-1990s; and the fact that the two studies did not
cover the full scope of efficiency costs. The current tax system, as
well as all major alternatives, imposes efficiency costs. As with the
case of compliance costs, the extent to which efficiency costs could be
reduced by tax system redesign would depend upon the details of the new
system.
Background:
The current tax system in the United States consists primarily of five
types of taxes: (1) personal income taxes; (2) corporate income taxes;
(3) social insurance taxes (employee and employer contributions for
Social Security, Medicare, and unemployment compensation); (4) estate
and gift taxes, and (5) a variety of other taxes such as excise taxes
on goods and services. Table 1 summarizes several selected features of
the current federal tax system.
Table 1: Features of the Tax System as of July 2005:
Type of tax: Personal Income Taxes (PIT);
Tax base: Regular PIT;
Personal income, including income from wages, interest and dividends,
capital gains, and small business income; Numerous tax expenditures
exist that reduce the size of the tax base;
Tax rates: Regular PIT;
Graduated rate structure: Statutory marginal rates of 10, 15, 25, 28,
33 percent, and 35 percent. Deductions and other tax expenditures, such
as refundable tax credits, such as the Earned-Income Tax Credit, create
a group of taxpayers who have no tax liability or receive an outlay
from the tax system.
Tax base: Personal Alternative Minimum Tax (AMT);
Taxable income exceeding certain threshold amounts based on filing
status;
Tax rates: Personal AMT; 26 or 28 percent depending on taxable income
subject to the AMT. Eligible for a credit for a portion of the AMT paid
in a prior year.
Type of tax: Corporate Income Taxes (CIT);
Tax base: Regular CIT;
Corporate profits (total revenues less total expenses). Numerous tax
expenditures exist that reduce the size of the tax base;
Tax rates: Regular CIT;
Statutory marginal rates fluctuate between 15 and 35 percent. Due to
special provisions, some corporations may pay a marginal tax rate of 39
percent.
Tax base: Corporate AMT;
Broader definition of the tax base (corporate income) than regular CIT,
less generous accounting rules;
Tax rates: Corporate AMT; 20 percent for all corporate income subject
to the tax less the AMT credit for that tax year.
Type of tax: Social Insurance Taxes;
Tax base: Social Security;
First $90,000 of employee wages;
Tax rates: Social Security; 6.2 percent employee contribution; 6.2
percent employer contribution; 12.4 percent for self-employed.
Tax base: Medicare;
All wages;
Tax rates: Medicare; 1.45 percent employee contribution; 1.45 percent
employer contribution; 2.90 percent for self-employed.
Type of tax: Unified Transfer Tax--Estate, Gift, and Generation
Skipping Tax[A];
Tax base: Estate Tax;
Fair market value of the decedent's cash and securities, real estate,
trusts, annuities, business interests, and other assets less allowable
deductions in excess of $1.5 million in 2005. There is an unlimited
deduction for transfers to a surviving spouse;
Tax rates: Estate Tax;
Maximum tax rate of 47 percent in 2005. As a result of recent tax
legislation, estate tax rates will fluctuate before the estate tax is
eliminated in 2010. However, the estate tax will be reinstated in 2011.
Tax base: Gift Tax;
Tax is imposed on lifetime taxable transfers of gifts of property.
Applicable exclusion amount of $1 million for 2005. In addition, there
is an annual exclusion of $11,000 per donee and an unlimited exclusion
for tuition and medical payments;
Tax rates: Gift Tax;
Maximum tax rate of 47 percent in 2005. Rates fluctuate in the same
manner as for the estate tax in coming years. Gift tax will be retained
following repeal of estate and generation skipping tax.
Tax base: Generation Skipping Tax (GST);
Total generation skipping transfers (such as from a grandparent to a
grandchild) in excess of $1.5 million in 2005;
Tax rates: Generation Skipping Tax; 47 percent (or highest statutory
marginal tax rate for the estate tax) in 2005. GST rates decrease until
the tax is repealed in 2010. GST is reinstated in 2011.
Type of tax: Excise and Other Taxes;
Tax base: Selected goods, services, and other items (e.g., gasoline,
alcoholic beverages, tobacco, airline tickets, etc.);
Tax rates: Various rates apply to different goods, services, and other
items.
Source: GAO analysis of IRS information.
[A] The unified transfer tax is based on the value of property to be
included in a decedent's estate at death and the value of taxable
lifetime gifts made by the decedent. Beginning in 2004, the estate and
gift tax applicable exclusion amounts differ.
[End of table]
The definition of the tax bases, the tax rates, the various tax
credits, and the specific characteristics of each taxpayer determine
how much that taxpayer must pay to the U.S. Treasury. The total cost of
taxes from a taxpayer's point of view is the sum of the tax liability,
the costs of complying with the tax system, and the efficiency costs
that the system imposes, as shown in figure 1. In subsequent sections
we discuss the various factors that cause the latter two types of
costs.
Figure 1: Components of the Total Cost of a Tax to Taxpayers:
[See PDF for image]
[End of figure]
Estimates of Tax Compliance Costs Are Uncertain Because Taxpayers
Generally Do Not Record Them; However, Total Costs Are Likely to Be
Large:
The costs of complying with the tax system are uncertain, but likely to
be large--estimates are roughly on the order of about 1 percent of GDP.
The costs include the computational, reporting, planning, and
recordkeeping requirements of the tax system. Estimates of compliance
costs are uncertain because taxpayers generally do not keep relevant
records documenting their time and money spent complying with the tax
system and many important elements of the costs are difficult to
measure because, among other things, federal tax requirements often
overlap with recordkeeping and reporting that taxpayers do for other
purposes.
Taxpayers Incur Costs When Complying with the Computational, Reporting,
and Recordkeeping Requirements of the Tax System:
The federal tax system imposes a wide range of recordkeeping, planning,
computational, and filing requirements upon businesses and individuals.
Complying with these requirements costs taxpayers time and money. Many
of these requirements are complex, reflecting both the complexity of
our modern economy and intent of policymakers to build progressivity
and various incentives into the tax system. As shown in figure 2, these
costs to taxpayers are above and beyond what they pay to the government
in taxes.
Figure 2: Compliance Burden Is One Cost Taxpayers Face in Complying
with the Tax System:
[See PDF for image]
[End of figure]
The tax compliance requirements for individuals include the
documentation of their incomes and their qualifications for various
exemptions, deductions, and credits available under the federal income
tax. Although the documentation of income is straightforward for a
large proportion of the individual taxpayer population who earn only
labor and interest income and capital income within a retirement
account, substantial numbers of taxpayers receive income from capital
gains, rents, self-employment, and other sources that involve
additional calculations and recordkeeping. In addition, many
individuals must familiarize themselves with (or pay someone to advise
them on) the sometimes complex rules for determining whether they
qualify (and, if so, to what extent) for any of the numerous tax
benefits in the federal tax code. Moreover, in cases where multiple tax
expenditures have similar purposes, taxpayers may have to devote
considerable time to learning and planning in order to make optimal use
of these tax benefits.
For example, the IRS publication Tax Benefits for Education[Footnote 1]
outlines 12 tax expenditures, including 4 different tax expenditures
for educational saving. Three of these savings tax expenditures--
Coverdell Education Savings Accounts, Qualified Tuition Programs, and
U.S. education savings bonds--differ across more than a dozen
dimensions, including the tax penalty that occurs when account balances
are not used for qualified higher education expenses, who may be an
eligible beneficiary, annual contribution limits, and other features.
Similarly, 3 other tax expenditures, all of which help students meet
current costs--the Hope credit, Lifetime Learning credit, and the
tuition deduction--differ in terms of eligibility criteria, benefit
levels, and income-related phase-outs. The use of one of these tax
expenditures can affect whether (or how) a taxpayer is allowed to use
the other tax expenditures. Moreover, the use of one of these tax
expenditures may affect a student's eligibility for other forms of
federal assistance for higher education, such as Pell grants and
subsidized loans.[Footnote 2]
Tax compliance requirements for businesses are even more extensive and
complex than those for individuals. Rules governing the computation of
taxable income, expense deductions, and tax credits of U.S.
corporations that do business in multiple foreign countries are
particularly complex. But even small businesses face multiple levels of
tax requirements of varying difficulty. In addition to computing and
documenting their income, expenses, and qualifications for various tax
credits, businesses with employees are responsible for collecting and
remitting (at varying intervals) several federal taxes on the incomes
of those employees. Moreover, if the businesses choose to offer their
employees retirement plans and other fringe benefits, they can
substantially increase the number of filings they must make. Businesses
also have information-reporting responsibilities--employers send wage
statements to their employees and to IRS; banks and other financial
intermediaries send investment income statements to clients and to
IRS.[Footnote 3] Finally, a relatively small percentage of all
businesses (which nevertheless number in the hundreds of thousands) are
required to participate in the collection of various federal excise
taxes levied on fuels, heavy trucks and trailers, communications, guns,
tobacco, and alcohol, among other products.
The tax filings and records of both individuals and businesses are
subject to review by IRS. Attempts at tax evasion, unintentional filing
errors, or differing interpretations of the tax law can all lead IRS to
request more information from taxpayers and, possibly, to litigation,
all of which would add to the taxpayers' costs.
Estimates of Compliance Costs Are Uncertain Because Relevant Records
Are Not Kept:
It is difficult for researchers to estimate the total compliance costs
of the federal tax system because taxpayers generally do not keep
records of the time and money spent complying with that tax system.
Moreover, many important elements of the costs are difficult to measure
because:
* recordkeeping and reporting to comply with federal tax requirements
often overlap with recordkeeping and reporting that taxpayers do for
other purposes;
* some costs that taxpayers incur in dealing with IRS may result from
tax evasion, rather than tax compliance; and:
* there is no consensus on the appropriate method for determining the
dollar-value of each hour that an individual spends on tax compliance.
Businesses and individual taxpayers have little, if any, motivation to
keep records of the time and money that they spend specifically on
complying with federal tax requirements. Consequently, when researchers
attempt to collect data on compliance costs, they typically have had to
contact samples of taxpayers, through surveys or interviews, and ask
them for their best recollection of the total time and money they spent
on particular compliance activities. Evidence from one past compliance
cost study suggests that respondent recall error may be
substantial.[Footnote 4] Moreover, conveying the appropriate definition
of federal tax compliance costs to mail or telephone survey respondents
and getting those respondents to apply that definition uniformly is
difficult, as will be clear from the discussion below. In fact, most of
the studies that we found had considerable difficulty getting
taxpayers, particularly businesses, to respond at all. A high response
rate is important for the accuracy of estimates, particularly for the
population of business taxpayers that is highly diverse in terms of
size, industry, and business organization and, therefore, is likely to
be diverse in terms of its compliance costs.
A major difficulty in measuring compliance costs is disentangling
accounting and recordkeeping costs due to taxes from the costs that
would have been incurred in the absence of the federal tax system. For
example, where the rules regarding the calculation of income for tax
purposes coincide with the rules for determining income for financial
statement purposes, the additional costs of taxation can be minimal.
Public corporations must file financial statements with the Securities
and Exchange Commission; other businesses are required to provide
financial statements to banks and other lenders when they are seeking
credit. Similarly, many individuals need to document their income when
applying for mortgages or financial aid for college. Moreover, most
businesses and individuals must comply with state, and sometimes local,
income tax filing requirements that are often very similar to those
imposed by the federal tax system. Consequently, if one wishes to
define the compliance costs attributable to the federal tax system as
only those costs that would not exist in the absence of that system,
then one needs to assume what the requirements of state and local tax
systems, as well as those of financial accounting systems, would look
like in the absence of the current federal tax system and make sure
that none of the costs of complying with those requirements are
included in the estimate of federal compliance cost. The studies that
we reviewed typically exclude normal business accounting costs from
their definition of federal tax compliance costs; however, they do not
exclude the costs of complying with tax requirements that are imposed
by both federal and state governments.
Two additional definitional issues that have been discussed in the
compliance cost literature are how to treat costs associated with
either tax planning or tax evasion. Although tax planning expenses are
excluded from the definitions of compliance costs established by the
Paperwork Reduction Acts of 1980 and 1995, some studies that we
reviewed do include such expenses in their definition of compliance
costs.[Footnote 5] None of the studies we reviewed recommended the
inclusion of costs associated with illegal tax evasion; however, it is
difficult for researchers to completely exclude tax evasion costs from
their estimates because, in many cases, the determination of whether a
particular activity constitutes tax evasion or not is not made until a
year or more after the activity is completed (and recorded in a
survey).
There is no consensus among researchers regarding the appropriate
monetary value to be assigned to each hour of time spent on tax
compliance activities. Some of the many issues involved in the choice
of the appropriate value are: whether to use different values for time
that is taken away from the taxpayer's leisure and time taken away from
additional hours at work; whether to use different values for time
spent on activities that the taxpayer could have paid someone to do and
time spent on activities that only the taxpayer could do; whether to
relate the value to each taxpayer's own hourly wage rate or to some
uniform wage rate; and whether to use a before-tax or after-tax wage
rate. The choice of the monetary value of an hour spent on tax
compliance obviously will have a substantial effect on the estimated
magnitude of aggregate compliance costs.
Existing Estimates of the Compliance Costs of the Federal Tax System,
Though Incomplete and Imprecise, Suggest Those Costs Are Large:
The government's Information Collection Budget (ICB), for the
Department of the Treasury, annually estimates the time that taxpayers
spend on prefiling and filing activities for every form issued by the
Treasury. The vast majority of these forms are tax related. Treasury
has estimated that during fiscal year 2004 individuals, businesses, and
exempt organizations spent a total of 6.4 billion hours on Treasury's
forms. Treasury does not convert this time estimate into a monetary
value. If this time burden were monetized at rates between $15 per hour
and $30 per hour (the range used for individual taxpayers in the
studies that we found), the total cost would amount to between about
$100 billion and $200 billion.
Many analysts within Treasury and outside believe that the ICB
estimates are not very accurate. The estimates are based primarily on
an IRS model that was developed with survey data for tax year 1983. The
simplicity of the model's approach for updating the data each year
leaves it with a very limited ability to adjust for changes in
compliance burden resulting from changes in tax policy or tax system
administration.[Footnote 6] Indeed, in an effort to more accurately
measure paperwork burden, IRS is currently developing a revised
methodology for estimating the compliance burden individuals incur when
complying with the U.S. tax system. The new model will reflect a change
in the approach for measuring burden: it focuses on the taxpayer and
the taxpayer's characteristics rather than the forms the taxpayer uses.
Key drivers of taxpayer burden in the model are the taxpayers'
activities and the method of return preparation (by a paid preparer, by
the taxpayer with tax preparation computer software, or by the taxpayer
without computer assistance). In addition, IRS is also working on new
methodologies for estimating the compliance burdens of various types of
businesses and tax-exempt entities, and the burdens associated with
postfiling activities.
Most of the other estimates of the compliance burden that we found for
large segments of the taxpayer population were produced by contractors
to IRS or by analysts who used IRS's data. The disparities among the
estimates, their likely margins of error, and their incompleteness (few
include postfiling costs, such as audits, and all are limited to the
income tax) prevent a more definitive conclusion about the total
compliance burden of the U.S tax system.
Studies we found that focus on the compliance costs of individual
taxpayers estimate it to be between $67 billion and a little over $100
billion per year. The variation in these estimates is primarily
attributable to the wide range in monetary values that the different
studies apply to an hour spent on tax compliance activities. These
studies are summarized and compared in table 2.
Table 2: Available Estimates of Tax Compliance Costs for Individual
Taxpayers (Including Self-employed):
Study: (publication date/estimate year)[A]: IBM/IRS; (2003/TY 2000);
Compliance costs: (dollars in billions): $67-99;
Important differences in scope and assumptions[B]:
* Covers taxpayers' time, preparer fees, and any other out-of-pocket
expenses;
* Taxpayers' time is monetized at $15 per hour for the low estimate and
at $25 per hour for the high estimate;
Notable methodological issues:
* Based on surveys of two samples of taxpayers: one (in 2000) for
individuals who earn only wage and investment income; a second (in
2001) for self-employed individuals.
Study: (publication date/estimate year)[A]: Moody--Tax Foundation;
(2002/CY 2002)[C];
Compliance costs: (dollars in billions): $104;
Important differences in scope and assumptions[B]:
* Covers taxpayers' and preparers' time but no out-of-pocket expenses;
* Taxpayers' and preparers' time is monetized at $30 per hour;
Notable methodological issues:
* Based on data from an IRS survey of taxpayers for TY 1983; the
methodology for updating that data is simplistic and does not account
for changes in tax preparation and recordkeeping technology.
Study: (publication date/estimate year)[A]: Slemrod; (2004/TY 2004)[D];
Compliance costs: (dollars in billions): $85;
Important differences in scope and assumptions[B]:
* Covers taxpayers' time, preparer fees, and any other out-of-pocket
expenses;
* Taxpayers' time is monetized at $20 per hour;
Notable methodological issues:
* Based on the author's informed judgment of accumulated research on
this topic, including his own study of a sample of Minnesota taxpayers
in 1989 (Slemrod and Blumenthal) and the IBM/IRS study.
[End of table]
Source: GAO analysis of papers cited.
[A] The abbreviations CY and TY stand for calendar year and tax year
respectively.
[B] The scopes of all of these studies are limited to the prefiling and
filing burden associated with taxpayers' own income tax returns; they
do not cover costs of complying with payroll or income tax
responsibilities with respect to any employees they may hire. None of
these studies includes postfiling costs, such as responding to notices
or providing information for audits.
[C] Moody included the self-employed in his estimate for business
burden. He also provided detailed estimates by specific tax forms. We
used this form-level detail to approximate his estimate for the self-
employed and shift that amount ($20 billion) from table 3 to this table
to improve comparability to the other studies.
[D] This estimate updates a similar exercise the author undertook in
1996.
Studies we found that focus on the compliance costs of businesses
estimate them to be between about $40 billion and $85 billion per year.
None of these estimates include the costs to businesses of collecting
and remitting income and payroll taxes for their employees. The
accuracy of these business compliance cost estimates is uncertain due
to the low rates of response to their data collection surveys. In
addition, the range in estimates across the studies is due, among other
things, to differences in monetary values used (ranging between $25 per
hour and $37.26 per hour), differences in the business populations
covered, and differences in the tax years covered. These studies are
summarized and compared in table 3.
Table 3: Available Estimates of Tax Compliance Costs for Corporations
and Partnerships:
Study: (publication date/estimate year)[A]: Moody--Tax Foundation;
(2002/CY 2002)[C];
Compliance costs: (dollars in billions): $85;
Important differences in scope and assumptions[B]:
* Covers all corporations and partnerships;
* Covers taxpayers' and preparers' time but no out-of-pocket expenses;
does not cover any postfiling costs;
* Taxpayers' and preparers' time is monetized at $37.26 per hour;
Notable methodological issues:
* Based on data from an IRS survey of taxpayers for TY 1983 (with a
response rate of less than 38 percent); the methodology for updating
that data is simplistic and does not account for changes in tax
preparation and recordkeeping technology.
Study: (publication date/estimate year)[A]: Slemrod and Venkatesh;
(2002/TY 2001);
Compliance costs: (dollars in billions): $22;
Important differences in scope and assumptions[B]:
* Excludes the largest 1,350 corporations, all businesses with less
than $5 million in assets, and all partnerships with less than a
certain number of partners;
* Covers taxpayers' time, preparer fees, and any other out-of-pocket
expenses, including all postfiling costs;
* Costs are stated in terms of businesses' actual expenses for in-house
or external tax compliance services;
Notable methodological issues:
* The effective response rate for the survey was only 10.25 percent;
* Large discrepancies existed between the estimates of outside expenses
given by the taxpayers versus those given by tax professionals;
* Large discrepancies existed between the asset sizes reported by IRS
versus the sizes reported by the taxpayers themselves. (Some
respondents may have reported as part of a consolidated group when they
were sampled to represent only a single corporation.)
Study: (publication date/estimate year)[A]: Slemrod; (2004/TY 2004);
Compliance costs: (dollars in billions): $40;
Important differences in scope and assumptions[B]:
* Covers all corporations and partnerships;
* Covers taxpayers' time, preparer fees, and any other out-of-pocket
expenses, but does not appear to cover postfiling costs;
* Taxpayers' time is monetized at $25 per hour;
Notable methodological issues:
* Represents author's best judgment, based on his other studies cited
in this table and an educated guess about the cost to small businesses
other than sole proprietors.
Study: (publication date/estimate year)[A]: Slemrod and Blumenthal;
(1993/TY 1992);
Follow-up study by Slemrod (1997/TY 1996);
Compliance costs: (dollars in billions): $2;
Important differences in scope and assumptions[B]:
* Covers only the 1,329 largest corporations;
* Covers taxpayers' time, preparer fees, and any other out-of-pocket
expenses, including all postfiling costs;
* Costs are stated in terms of businesses' actual personnel costs for
in-house tax compliance activities and all costs for external tax
compliance services;
Notable methodological issues:
* Response rate for the 1992 survey was 27.5 percent;
* Slemrod (1997) did a follow-up survey in 1996 that had a lower number
of respondents. The overall cost estimate was roughly the same in each
study.
Source: GAO analysis of the papers cited.
[A] The abbreviations CY and TY stand for calendar year and tax year
respectively.
[B] The scopes of all of these studies are limited to the taxpayers'
own income tax returns; they do not cover costs of complying with
payroll or income tax responsibilities with respect to their employees.
[C] This study estimated that nonprofits spent over $5 billion on
compliance costs (above and beyond the $85 billion). None of the other
studies included the costs of nonprofits.
[End of table]
Frequent changes to the tax code over time reduce the relevance of past
estimates of compliance costs to policymakers who are interested in the
costs of the current system. Since the comprehensive tax reform of 1986
there have been changes to the tax code every year; many of these
changes can be characterized as major.[Footnote 7] Two examples of the
numerous changes that have likely affected compliance burden are:
* the revenue provisions of the Small Business Job Protection Act of
1996[Footnote 8] that tightened the pension nondiscrimination rules
that businesses must follow; and:
* the creation of Hope and Lifetime credits for post-secondary
education (in the Taxpayer Relief Act of 1997[Footnote 9]); the fact
that taxpayers must chose between the two credits adds to their need
for tax planning.
The Extent to Which Compliance Costs Could be Reduced Depends Upon the
Details of a Redesigned Tax System:
The estimates presented above do not represent the potential cost
savings to be gained by replacing the current federal tax system. Any
replacement tax system will impose significant compliance costs of its
own. Moreover, given that many state and local government income taxes
depend upon the same compliance activities as the federal income tax
does, taxpayers would still bear the costs of those activities unless
those other governments replaced their own taxes to conform to the new
federal system. In addition, if some of the subsidies, such as the
earned income tax credit and the research tax credit, that are provided
by the current federal tax system are replaced by spending programs
under a reformed system, tax compliance costs may be reduced, but only
as a result of their being shifted to those new programs. Similarly, if
a replacement tax system no longer requires businesses and individuals
to compute and document their incomes, those businesses and individuals
will still need to document their incomes for borrowing and other
purposes, and government statistical agencies will incur expenses to
replace the data that they currently obtain from income tax returns.
Efficiency Costs Arising from Tax-Induced Changes in Behavior Are
Likely to Be Large but Can Only Be Modeled with Considerable
Uncertainty:
Economic efficiency costs occur when tax rules cause individuals to
change their work, savings, consumption, and investment behavior in
ways that ultimately leave them with a combination of consumption and
leisure (now and in the future) that they value less than the
combination they would have obtained under a tax system that did not
distort their behavior. Estimating efficiency costs is very challenging
because the tax system has such extensive and diverse effects on
behavior. We found no comprehensive estimates of the efficiency costs
of the current federal tax system. However, we did find some studies
that estimate the efficiency costs attributable to selected aspects of
the current system. Although none of these studies, either individually
or in the aggregate, provide a basis for estimating the total
efficiency cost of the tax system, they do indicate that those total
costs are likely to be large. The more comprehensive estimates show
costs on the order of 2 to 5 percent of GDP each year. However, the
efficiency cost of the current tax system may not fall within that
range because of uncertainty surrounding taxpayer's behavioral
responses to tax rules, changes in the tax code and the economy since
the mid-1990s, and the studies do not cover all of the sources of
efficiency costs.
Efficiency Costs Arise When Taxpayers Alter Their Behavior in Response
to Tax Rules:
Many aspects of the federal tax system provide incentives or
disincentives for taxpayers to undertake particular activities. Some of
these incentives and disincentives were intentionally designed into the
system; others are unintended consequences of rules designed to achieve
other objectives, such as equity or increased revenue yield. By
changing the relative attractiveness of highly taxed and lightly taxed
activities, taxes alter decisions such as what to consume and how to
invest. Households and firms generally respond to taxes by choosing
more of lower taxed items and less of higher taxed items than they
would have otherwise. When taxpayers alter their behavior in response
to tax rules, they often end up with a combination of consumption
(broadly defined) and leisure that they value less than the combination
they could have achieved if they made decisions free of any tax
influences. Economists refer to this reduction in value as a "welfare
loss" or an efficiency cost; they also generally refer to behavioral
changes in response to taxes as "distortions," even though not all
changes have negative consequences.[Footnote 10]
Figure 3: Efficiency Costs Are One Cost Taxpayers Face in Complying
with the Tax System:
[See PDF for image]
[End of figure]
As an example of the efficiency costs of taxes, suppose an investor is
choosing between two potential investments, one that has an expected
return of $1.10 on every dollar invested and a second that has an
expected return of $1.20. If neither investment is taxed, or if the
investments are taxed equally, the investor will choose the second
investment with its higher economic rate of return. However, if the
first investment continues to be untaxed, while the second is subject
to a 10 percent tax, the decision will be based on the investments'
after-tax rates of return. In this case the after-tax return on the
first investment continues to be $1.10 for every dollar invested, while
the after-tax return on the second investment is now $1.08. An investor
would choose the first investment because it has a higher after-tax
return. This tax distortion causes investors to earn $.10 less on every
dollar invested, relative to the no-tax case, even though no tax is
paid to the government. This decline in income ultimately leads to
lower total consumption.
Efficiency gains or costs are not the same as increases or decreases in
economic output (normally measured in terms of GDP). For example, a
reduction in taxes on wages could encourage some individuals to
increase the number of hours they work, which in turn would increase
economic output and the amount of consumption those workers could
achieve. However, the welfare gain to these individuals may be
considerably less than the increase in their consumption because they
would have to forego some leisure time that they value in order to
achieve the gain in welfare. In fact, some researchers who have
examined both the output and efficiency effects of replacing the
current tax system with various alternatives have reached similar
conclusions concerning output effects while reaching different
conclusions concerning the efficiency effects of similar
alternatives.[Footnote 11]
The efficiency gain or loss due to a change in a tax system is defined
as the difference between total welfare that is achieved under the
existing tax system and that which would be achieved under the
replacement system that raised the same amount of revenue. The total
efficiency cost of the current federal tax system would have to be
estimated by comparing it to a tax system that raised the same amount
of revenue while generating no efficiency costs at all--in other words,
a tax system that had no effect on taxpayers' behavior at all. Although
such distortion-free tax systems can be designed in theory, none exist
as primary sources of revenue in practice because they are generally
viewed as inequitable.[Footnote 12]
Estimates of Efficiency Costs Are Highly Uncertain Because the Tax
System Has Such Extensive and Diverse Effects on Behavior:
Estimating the efficiency costs of the federal tax system is an
enormous, complicated, and uncertain task, given the complexity of
existing tax rules, the breadth and diversity of the U.S. economy and
population, and the limited empirical evidence available regarding how
individuals and businesses change their behavior in response to tax
rules. In order to obtain a precise estimate of the efficiency costs
researchers would need to identify all of the significant incentives
and disincentives imbedded in the federal tax system; they would also
need to know the extent to which large, heterogeneous populations of
individuals and businesses have changed their behaviors in response to
these incentives.[Footnote 13]
In practice, researchers have not been able to obtain and analyze all
of the detailed data they need to produce efficiency cost estimates
that are free from a large degree of uncertainty. The mathematical
models that are used to analyze the important interrelating and
cascading effects of the entire tax system, or even significant
components of the system, are quite complex, even when researchers
limit their examination to highly simplified representations of the
actual taxes. It is impractical to incorporate all of the significant
details of tax rules that result in efficiency costs. Similarly, data
constraints and computational practicality lead researchers to limit
the extent to which their models reflect the variations in behavioral
responses to various tax rules across large and heterogeneous
populations of businesses and individuals. Finally, researchers
attempting to estimate efficiency costs often have little, or
conflicting, empirical evidence upon which to base their assumptions
about various behavioral responses to tax distortions because the
underlying research into those behavioral responses is, itself, subject
to considerable uncertainty. For example, one piece of information that
is critical to the estimation of efficiency costs is the extent to
which individuals' taxable incomes change in response to tax changes.
Researchers have had difficulty estimating this responsiveness because
of the difficulty of controlling for all of the other factors that
affect income growth, such as changes in the economic environment,
returns to investments in education, and the changing age distribution
of the population. Moreover, this responsiveness is likely to be
different for different subpopulations of taxpayers.[Footnote 14]
While No Comprehensive Estimates of the Tax System's Efficiency Costs
Exist, Available Partial Estimates Suggest Those Costs Are Large:
None of the studies we reviewed provides a comprehensive estimate of
the efficiency cost of the U.S. federal tax system since the tax reform
of 1986. However, a variety of studies do provide some evidence that
the efficiency costs are large. All of these studies are summarized in
table 4. The more comprehensive studies we found show costs on the
order of 2 to 5 percent of GDP each year (as of the mid-1990s). The
other studies that we reviewed examined more limited aspects of the tax
system's distortions. The efficiency cost estimates for those selected
distortions cannot be summed directly to an overall estimate; however,
they are each significant enough to support the conclusion that the
combined cost of all distortions is large.
Table 4: Estimates of the Efficiency Gains from the Removal of Selected
Distortions in the Current Tax System:
Feldstein (1999):
Employs his own estimates of the responsiveness of taxable income to
tax changes and those of other researchers to estimate the efficiency
gains from replacing personal income and payroll taxes with revenue-
neutral nondistorting taxes. Estimated efficiency costs of $137 billion
to $363 billion in 1994. The author recognizes that the responsiveness
of taxable income to changes in taxes is a key parameter, subject to
ongoing research and that a range of estimates exist. This cost recurs
each year;
Tax(es) included in the study: Personal Income Tax; Payroll Tax;
Behavior altered: Work versus leisure;
Tax-preferred consumption (e.g., fringe benefits) versus other
consumption.
Gravelle (2004, 1989); Gravelle and Kotlikoff (1993):
Simulates how taxes affect the allocation of capital investment across
the corporate and noncorporate sectors. Estimated efficiency costs of
nearly $13 billion in 1988, based upon one set of assumptions. This
cost recurs each year. In 2004, the author notes that the subsequent
reduction in taxes on dividends has contributed to a decrease in the
efficiency cost from the corporate/noncorporate distortion;
Tax(es) included in the study: Personal Income Tax; Corporate Income
Tax;
Behavior altered: Corporate versus noncorporate investment.
Cai and Gokhale (1997):
Estimates how taxes on capital income distort decisions about when and
what to consume. Estimated efficiency costs of $45 billion in 1995, in
the authors' base-case. The authors note that the distortion can be
substantial for the consumption of durable goods, such as housing,
which have relatively low rates of depreciation. This cost recurs each
year;
Tax(es) included in the study: Selected Aspects of the Personal Income
Tax; Selected Aspects of the Corporate Income Tax;
Behavior altered: Current consumption versus savings;
Durable consumption versus nondurable consumption.
Lui and Rettenmaier (2002, 2004):
Estimates the excess burden of the Social Security payroll taxes using
two estimates of labor supply responsiveness. Estimated efficiency
costs range from $49 billion to $82 billion in 2001, depending on the
degree of labor supply responsiveness assumed. The authors note that
their estimates do not include impacts of payroll taxes on savings
decisions or tax-preferred consumption. This cost recurs each year. In
the second paper the authors suggest an alternative derivation of the
excess burden, which produces estimates that are 10 to 50 percent of
the original;
Tax(es) included in the study: Social Security Payroll Tax;
Behavior altered: Work versus leisure.
Holtz-Eakin and Marples (2001a, 2001b):
Estimates the efficiency cost associated with the distortion of wealth
accumulation decisions by the estate tax relative to a uniform tax on
capital income. Estimated efficiency cost of $38.4 billion in 1999,
using the authors' preferred set of assumptions. The authors note that
their data exclude the "super-rich" who are most affected by the tax
and that the literature on the percentage of bequests that are
intentional presents a large range of estimates. This cost recurs each
year;
Tax(es) included in the study: Estate Tax;
Behavior altered: Wealth accumulation and allocation to bequests versus
lifetime consumption and other lifetime uses of wealth.
Jorgenson and Yun (2001):
Estimates the efficiency cost of replacing the personal and corporate
income tax with a nondistortionary revenue neutral tax. Estimated
efficiency costs at the local, state, and federal level of 19.5 percent
of combined collections. If applied to only federal collections, this
would equal about $200 billion in 1997;
Tax(es) included in the study: Personal and Corporate Income; Taxes at
the Federal, State, and Local level;
Behavior altered: Behaviors altered by the personal income tax, such as
savings, work effort, and housing choices; and behaviors altered by the
corporate income tax, such as debt versus equity finance,
organizational form, and dividend decisions.
Source: GAO analysis of papers cited.
[End of table]
The two studies with the broadest scopes among those that we reviewed
were by Jorgenson and Yun and by Feldstein.[Footnote 15] The first set
of authors estimated that the efficiency cost of federal taxes on
capital and labor income in 1997 was equal to about 19.5 percent of the
revenues collected from those taxes.[Footnote 16] Applying this
percentage to federal corporate and personal income tax collections in
1997 would yield efficiency costs of about $200 billion or, roughly,
2.5 percent of GDP in that year. Feldstein examined the effects of
several distortions caused by the federal personal income tax and
payroll taxes, including those related to decisions about how much to
work and what to consume. He estimated that these distortions resulted
in efficiency costs of between $137 billion and $363 billion in 1994
(depending on his assumptions regarding the size of taxes effects on
various decisions). Those estimates were roughly equivalent to between
2 and 5 percent of GDP in 1994.
The other studies that we found focused on more limited aspects of the
tax distortions caused by the federal tax system. For example, Cai and
Gokhale examined how selected aspects of the federal personal and
corporate income taxes distorted the choices between savings and
consumption and found that these distortions generated $45 billion per
year in efficiency costs as of 1995. As another example, Holtz-Eakin
and Marples found that the distorting effect of the estate tax on
choices among consumption, leisure, and wealth accumulation resulted in
efficiency costs of over $38 billion in 1999.
The estimates from the various studies shown in table 4 cannot be
combined to obtain a comprehensive estimate of the current tax system's
efficiency costs for several reasons. First, no combination of the
estimates covers all of the tax system's distortions (e.g., none of the
estimates cover the effects of payroll taxes on savings). Second, an
estimate of the costs arising from all of the tax system's distortions
can only be made by examining the removal of all of the distortions
simultaneously.[Footnote 17] Finally, the various estimates are made
for different years and, therefore, reflect different tax systems, each
of which is somewhat different than today's system. As noted earlier,
there have been frequent and significant changes to the tax system
since 1986. Even as recently as 2001 and 2003 there have been changes
that are likely to have affected the efficiency costs of federal income
taxes. For example, the Economic Growth and Tax Relief Reconciliation
Act of 2001 (EGTRRA)[Footnote 18] decreased the marginal tax rates on
individual income and estates and increased the exemption from estate
taxes. These changes could have decreased the efficiency cost for
individuals. Also, Gravelle (2004) notes that the temporary reduction
in taxes on dividends contained in the Jobs and Growth Tax Relief
Reconciliation Act of 2003[Footnote 19] contributed to a reduction of
the corporate/noncorporate distortion and its efficiency costs.
Nevertheless, the estimated efficiency costs associated with the
selected distortions are significant enough individually to suggest
that the total efficiency cost of the tax system is large.
We also reviewed a number of other studies that estimated the
difference in efficiency costs between existing federal income taxes
and potential substitutes for those taxes.[Footnote 20] These estimates
do not represent the absolute costs of the existing taxes because the
substitute taxes all generate efficiency costs of their own; however,
they would (to the extent that they are accurate) represent lower
bounds for those costs. The findings of these studies varied
considerably, depending on the nature of the taxes that were presumed
to replace the federal income taxes. For example, Lim Rodgers and
Jorgenson and Wilcoxen found that there would be little, if any,
efficiency gain from replacing the existing income taxes with a
consumption-based flat tax.[Footnote 21] In contrast, Jorgenson and Yun
estimated that the efficiency gains of replacing income taxes with a
pure flat-rate income and/or sales tax would yield gains of about $210
billion per year (measured in 1997 dollars).[Footnote 22]
As noted earlier, considerable uncertainty surrounds all of the
estimates we have cited. The estimation of efficiency costs involves
complicated modeling based on numerous assumptions about the behavioral
responses of individuals and businesses to changes in taxes and other
factors. Results are often quite sensitive to the assumed magnitude of
key responses and those assumptions are often based on empirical
research that continues to evolve over time or, in other cases, has yet
to be undertaken. For example, the consensus of recent research is that
individuals are less responsive to changes in taxes than Feldstein
assumed them to be when he made his estimates. As another example,
Holtz-Eakin and Marples noted that there was significant disagreement
in the empirical research over one of the factors that was key to their
estimate--the extent to which actual bequests differed from intended
bequests.
The Extent to Which Efficiency Costs Can be Reduced by Tax System
Redesign Is Uncertain:
As some of the results presented in the preceding section demonstrate,
the extent to which efficiency gains could be realized by switching to
an alternative tax system depends critically on the detailed
characteristics of the alternative. All of the alternative tax system
proposals that have received serious consideration in recent decades
would have imposed significant efficiency costs. Moreover, in assessing
the potential efficiency gains from any tax reform proposal it is also
important to consider compensating changes that may be made on the
spending side of the federal budget. For example, if any tax
expenditures in the current federal income taxes are replaced by
grants, spending programs, regulations, or other forms of nontax
subsidies, those subsidies can result in efficiency costs similar in
magnitude to those associated with the tax expenditures they replaced.
Agency Comments and Our Evaluation:
We provided a draft of this report in August 2005 to the Commissioner
of Internal Revenue. We received technical comments via e-mail from the
IRS Office of Research. Where appropriate, we made changes in our
report in response to these comments.
As agreed, unless you announce the contents of this report earlier, we
plan no further distribution until 30 days from the date of this
report. At that time, we will make copies available to others on
request. In addition, the report will be available at no charge on the
GAO Web site at [Hyperlink, http://www.gao.gov].
If you or your staff have any questions on matters discussed in this
report or would like additional information, please contact me at (202)
512-5594 or [Hyperlink, whitej@gao.gov]. Contact points for our Offices
of Congressional Relations and Public Affairs may be found on the last
page of this report. Key contributors to this report were James Wozny
and Donald Marples.
Signed by:
James R. White:
Director, Strategic Issues:
[End of section]
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FOOTNOTES
[1] Department of the Treasury, IRS, Publication 970, Tax Benefits for
Education, 2004.
[2] For a fuller discussion of the difficulties that taxpayers face
when trying to make use of the various tax expenditures for education,
see GAO, Student Aid and Postsecondary Tax Preferences: Limited
Research Exists on Effectiveness of Tools to Assist Students and
Families through Title IV Student Aid and Tax Preferences, GAO-05-684
(Washington, D.C. July 29, 2005).
[3] Although this information reporting increases the compliance burden
on businesses, it does enable IRS to enforce tax compliance by wage
earners and investors at lower cost. This reduction in administrative
costs, which are paid out of the federal budget, means that taxes are
slightly lower than they otherwise would have to be.
[4] As part of the study that forms the basis for IRS's current
estimates of compliance costs, the study's authors used two data
collection methods--a mail survey and a diary study. The cost estimates
yielded by the two methods varied significantly. The average burden of
14.8 hours for the mail survey respondents was 78 percent higher than
the average burden of 8.3 hours reported by diary respondents.
[5] Pub. L. No. 96-511 (1980) and Pub. L. No. 104-13 (1995).
[6] The only factors used in the model are measures of return size
(numbers of forms and attachments), form size (number of words or
number of line items), the number of references to the tax code in
forms, and instructions, and the number of line items requiring
records. The model does not take into account new developments in tax
preparation technology, such a personal computer software and
electronic filing, nor does it differentiate between simple and complex
types of line items on tax forms.
[7] According to The President's Advisory Panel on Federal Tax Reform,
Staff Presentation on Complexity and Instability presented on July 20,
2005, there have been 14,400 changes to the tax code since 1986.
[8] Pub. L. No. 104-188 (1996).
[9] Pub. L. No. 105-34 (1997).
[10] A tax on pollution is an example of an efficiency-enhancing tax
that causes a beneficial change in behavior. Pollution may be viewed as
a negative product that consumers are involuntarily forced to consume.
A tax on pollution can provide polluters with an incentive to reduce
their emissions, thereby increasing the well-being of consumers.
[11] For example, both Jorgenson and Yun, Investment Volume 3: Lifting
the Burden: Tax Reform, the Cost of Capital, and U.S. Economic Growth,
(Cambridge, Massachusetts, MIT Press, 2001) and Alan Auerbach, "Tax
Reform, Capital Allocation, Efficiency and Growth," in Economic Effects
of Fundamental Tax Reform (Washington, D.C., Brookings Institution
Press, 1996) examine the output and efficiency effects of changing to a
consumption-based tax. While they both find significant output effects,
only Jorgenson and Yun consistently find large efficiency gains from
switching to a consumption tax.
[12] A head tax, which is a tax that collects the same amount of money
from all taxpayers regardless of how much they earn or consume, is an
example of a tax that does not distort behavior. This type of tax does
not meet either of the two commonly recognized criteria for equitable
taxes--first, that tax liabilities should be related to taxpayers'
ability to pay and, second, that tax liabilities should reflect the
benefits that taxpayers receive from the government.
[13] Moreover, it is not sufficient simply to know how various tax
incentives directly distort an individual's or business' decisions. The
researchers would also need to know how those distorted decisions, in
turn, caused other decisions to be distorted in a cascading effect. For
example, the distortion of savings decisions can affect the amount of
investment in the economy, which in turn can affect the productivity of
labor and, therefore, the wage rate paid to labor (which generally is
directly related to the productivity of labor). The change in the wage
rate then affects individuals' choices between work and leisure.
[14] Seth Giertz, Recent Literature on Taxable Income Elasticities,
Congressional Budget Office Technical Paper Series, number 2004-16,
December 2004.
[15] Jorgenson and Yun 2001 and Martin Feldstein, "Tax Avoidance and
the Deadweight Loss of the Income Tax," The Review of Economics and
Statistics, 1999.
[16] The authors actually estimate the cost of these taxes at the
federal, state, and local level; however, one of the authors told us
that the costs as a percentage of revenue should be approximately the
same if the state and local taxes were excluded from the analysis.
[17] For example, Douglas Holtz-Eakin and Donald Marples, "Distortion
Costs of Taxing Wealth Accumulation: Income Versus Estate Tax,"
National Bureau of Economic Research Working Paper 8261, 2001,
estimated the efficiency costs of the estate tax in the presence of all
of the distortions associated with the federal income taxes. Their
estimate could have been significantly different if they had assumed
that a nondistortionary tax had been in effect at that time, instead of
the income taxes. For this reason, it is inappropriate to assume that
eliminating the distortions of the estate tax would have yielded the
same $38.4 billion in 1999 on top of the gains that Jorgenson and Yun
2001 estimate could have been realized by removing all income tax
distortions.
[18] Pub. L. No. 107-16 (2001).
[19] Pub. L. No. 180-27 (2003).
[20] In addition, a number of studies have estimated the effects of
fundamental tax reform on economic output. However, as we noted
previously, output effects are not the same as efficiency effects, so
those output estimates are not relevant to the questions addressed in
this report.
[21] The characteristics of this replacement tax were specified by the
Joint Committee on Taxation as part of an exercise for a symposium that
the committee organized to test the feasibility of incorporating
macroeconomic effects in revenue estimates. See JCS-21-97, "Joint
Committee on Taxation Tax Modeling Project and 1997 Symposium Papers,"
November 20, 1997, for a complete description.
[22] These replacement taxes in Jorgenson and Yun 2001 are "pure" in
the sense that they have no exemptions (except for investment goods in
the case of the sales tax), deductions, credits, or special rates.
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