Individual Income Tax Policy: Streamlining, Simplification, and
Additional Reforms Are Desirable (03-AUG-06, GAO-06-1028T).
The federal government currently relies heavily on the individual
income tax and payroll taxes for about 80 percent of its total
annual revenue. Long-range projections show that without some
form of policy change, the gap between revenues and spending will
increasingly widen. The debate about the future tax system is
partly about whether the goals for the nation's tax system can be
best achieved by reforming the current income tax so that it has
a broader base and flatter rate schedule, or switching to some
form of consumption tax. This testimony reviews the revenue
contribution of the current individual income tax as well as its
complexity, economic efficiency, equity, and taxpayer compliance
issues; discusses some common dimensions to compare tax
proposals; and draws some conclusions for tax reform. This
statement is based on previously published GAO work and reviews
of relevant literature.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-06-1028T
ACCNO: A57940
TITLE: Individual Income Tax Policy: Streamlining,
Simplification, and Additional Reforms Are Desirable
DATE: 08/03/2006
SUBJECT: Budget deficit
Consumption taxes
Federal taxes
Fiscal policies
Income taxes
Noncompliance
Personal income taxes
Tax administration systems
Tax violations
Taxes
Tax gap
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GAO-06-1028T
* Background
* The United States Faces a Large and Growing Structural Budge
* Revenues from the Current Tax System Are Not Sufficient to F
* The Individual Income Tax Is the Largest Single Source of Fe
* Individual Income Tax Complexity, Compliance, and Efficiency
* Important Sources of Complexity Are Income Documentation Req
* Tax Expenditures Have Been Growing
* Although Difficult to Measure, Compliance Burden Is Likely a
* Taxes Generally Reduce Economic Efficiency
* Efficiency Costs Resulting from the Individual Income Tax Ar
* Perceptions of Inequities in the Tax System Can Undermine It
* Ensuring Individual Taxpayer Compliance with the Tax Laws Is
* Comparing Proposals on Common Dimensions
* Concluding Observations
* Contact and Acknowledgments
* GAO's Mission
* Obtaining Copies of GAO Reports and Testimony
* Order by Mail or Phone
* To Report Fraud, Waste, and Abuse in Federal Programs
* Congressional Relations
* Public Affairs
Testimony
Before the Committee on Finance, U.S. Senate
United States Government Accountability Office
GAO
For Release on Delivery Expected at 10:30 a.m. EDT
Thursday, August 3, 2006
INDIVIDUAL INCOME TAX POLICY
Streamlining, Simplification, and Additional Reforms Are Desirable
Statement of David M. Walker Comptroller General of the United States
GAO-06-1028T
Mr. Chairman and Members of the Committee:
I appreciate this opportunity to contribute to your consideration of
fundamental tax reform by discussing the individual income tax. Although
the focus of my statement is the individual income tax, it clearly makes
sense to consider a broader reform encompassing both the individual and
corporate income taxes and much of my message is applicable to broad
reforms.1
As the Committee is well aware, two fundamental objectives of a tax system
are (1) to raise revenue sufficient to fund projected spending and (2) to
do so in a manner that is fair, relatively easy to administer, and
minimizes negative effects on the economy. Unfortunately, over time, the
accumulated changes to our individual tax system have not been consistent
with these objectives and, not surprisingly, there is a growing debate
about the fundamental design of the current tax system.
The debate about the future tax system is partly about whether the goals
for the nation's tax system can be best achieved by reforming the current
income tax so that it has a broader base and a flatter rate schedule, or
switching in whole or in part to some form of a consumption tax. The
President's Advisory Panel on Federal Tax Reform has taken a major step in
beginning this debate.2 The Panel suggested two alternative proposals for
coordinated reform of the individual and corporate income taxes and
thereby advanced the public debate over how best to simplify these taxes
and their proposals include the desirable combination of broader tax bases
and lower tax rates.
My statement reviews the revenue contribution of the current individual
income tax as well as its complexity, economic efficiency, equity, and
taxpayer compliance issues. It also draws some conclusions regarding the
need for tax reform. My statement today makes the following points:
o The debate about the fundamental design of the tax system is
occurring at a time when the nation also faces a large and growing
structural budget deficit, as under current policy, the gap
between revenues and spending will widen over the next few
decades. The individual income tax has long been the single
largest source of federal tax revenue-amounting to $927 billion in
2005. Individual income tax policy, including existing tax
expenditures and enforcement approaches, needs to be an element of
a multipronged approach that reexamines existing federal policies
and approaches to address the nation's large long-term fiscal
imbalance.
o Concerns regarding the complexity, economic efficiency, and
overall equity of the individual income tax have contributed to
calls for a substantial restructuring of the individual tax or its
full or partial replacement with some form of consumption tax. The
widely recognized complexity of the tax results in (1) significant
compliance costs, frustration and anxiety for taxpayers; (2)
decreased voluntary compliance; (3) increased difficulties for the
Internal Revenue Service (IRS) in administering the tax laws; and
(4) reduced confidence in the fairness of the tax. As discussed in
our publication, Understanding the Tax Reform Debate3 the
individual income tax also causes taxpayers to change their work,
savings, investment, and consumption behavior in ways that reduce
economic efficiency and taxpayers' well-being.
o Taxpayer noncompliance with the current individual income tax
is another factor that could motivate reform. For tax year 2001,
IRS estimated that noncompliance with the individual income tax
accounted for about 70 percent of the $345 billion gross tax gap,
which is the difference between the taxes that should have been
paid voluntarily and on time and what was actually paid. Reducing
this gap can improve the nation's fiscal stability, as each 1
percent reduction in the tax gap would likely yield about $3
billion annually. Given its persistence and size, reducing the tax
gap within the current income tax structure will require exploring
new and innovative administrative and legislative approaches.
o In moving forward on tax reform, policymakers may find it
useful to compare alternative proposals along some common
dimensions. Among these are whether a proposed tax system will
generate sufficient revenue over time to fund whatever spending
path is chosen, whether the base is as broad as possible so rates
can be as low as possible, and whether it has attributes that
promote compliance. Our publication, Understanding the Tax Reform
Debate, provides background, criteria, and questions that
policymakers should find useful. 4
My statement today is drawn from previous GAO reports and
testimonies, which were done in accordance with generally accepted
government auditing standards, as well as reviews of relevant
literature.
Background
The base of the individual income tax covers income paid to
individuals, such as wages, interest, dividends, realized net
capital gains, various forms of business income, and income from
pensions, annuities, trusts and estates. This tax base is reduced
by personal exemptions for taxpayers and their spouses and
children, as well as by numerous preferences-statutorily defined
as tax expenditures-such as the deduction for mortgage interest,
the earned income tax credit, and the exclusion of the value of
employer-provided health insurance from individuals' taxable
income and taxable wage base. The statutory rates of tax on net
taxable income range from 10 percent to 35 percent. Lower rates (5
percent and 15 percent, depending on taxable income) apply to
long-term capital gains and dividend income.
Individuals may also pay tax under the alternative minimum tax
(AMT). The base of this tax equals regular taxable income, plus
the value of various tax items, including personal exemptions and
certain itemized deductions that are added back into the base.
This AMT income base is then reduced by a substantial exemption
and then taxed at a rate of 26 percent or 28 percent, depending on
the taxpayer's income level. Taxpayers compare their AMT tax
liabilities to their regular tax liabilities and pay the greater
of the two.
Although the income tax applies to all who have taxable income,
nearly all workers pay social insurance taxes to fund retirement,
disability and retiree health programs. According to Congressional
Budget Office estimates, in 2000 over 40 percent of households
paid more in just their portion of social insurance taxes than
they paid in income taxes. Further, when both their contribution
and their employers' is counted, over 70 percent of households
paid more in social insurance taxes than they did in income taxes.
The consensus among economists is that the employees ultimately
bear the entire social insurance tax burden. In 2005 workers paid
a total of $794 billion in social insurance taxes to fund federal
social insurance, retirement, disability, and retiree health
programs. This amount was in addition to their income tax
liabilities. From the taxpayers' view, these taxes may not appear
significantly different than income taxes. They reduce the
workers' take-home pay each pay period and, although the taxes are
set aside in a separate account to fund specific benefits, the
portion of these taxes not immediately needed for current
beneficiaries goes to fund current government expenses just like
income taxes.
Three long-standing criteria-equity; economic efficiency; and a
combination of simplicity, transparency, and administrability-are
typically used to evaluate tax policy. These criteria are often in
conflict with each other and, as a result, there are usually
trade-offs to consider and people are likely to disagree about the
relative importance of the criteria.
To the extent that a tax is not simple and efficient, it imposes
costs on taxpayers beyond the payments they make to the U.S.
Treasury. As shown in figure 1, the total cost of any tax from a
taxpayer's point of view is the sum of the tax liability, the cost
of complying with the tax system, and the economic efficiency
costs that the tax imposes. In deciding on the size of government,
we balance the total cost of taxes with the benefits provided by
government programs.
Figure 1: Components of the Total Cost of a Tax to Taxpayers
The United States Faces a Large and Growing Structural Budget Deficit
Over the long term, the United States faces a large and growing
structural budget deficit primarily caused by known demographic
trends and rising health care costs, and this deficit is
exacerbated over time by growing interest on the ever larger
federal debt. Continuing on this imprudent and unsustainable
fiscal path will gradually erode, if not suddenly damage, our
economy, our standard of living, and ultimately our national
security. Addressing the nation's long-term fiscal imbalances
constitutes a major transformational challenge that may take a
generation or more to resolve. Fiscal necessity may prompt a
fundamental review of major program and policy areas. Many current
federal programs and policies-including tax policies-were designed
decades ago to respond to trends and challenges that existed then
but may no longer suit our 21st century needs. Clearly, the
individual income, social insurance, and corporate income taxes,
which have been the federal government's three largest sources of
revenue, will need to be considered in any plan for addressing the
nation's long-term fiscal imbalance.
Revenues from the Current Tax System Are Not Sufficient to Fund
Projected Spending
Over the next few decades, as the baby boom generation retires,
federal spending on retirement and health programs, such as Social
Security, Medicare, and Medicaid, will grow dramatically and bind
the nation's fiscal future. Absent policy changes on the spending
and/or revenue sides of the budget, a growing imbalance between
federal spending and tax revenues will mean escalating and
ultimately unsustainable federal deficits and debt. In simple
terms, the gap between projected spending and expected revenues
grows larger every year. For example, as figure 2 indicates, if
discretionary spending grows at the same rate as the economy, all
expiring tax provisions are extended, and then federal revenues
are held as a constant share of the economy, revenues could be
adequate to cover little more than interest on the federal debt by
2040.
1I addressed a number of issues relating to the corporate income tax in a
statement before this committee several weeks ago. See GAO, Tax
Compliance: Challenges to Corporate Tax Enforcement and Options to Improve
Securities Basis Reporting, GAO-06-851T (Washington, D.C.: June 13, 2006).
2President's Advisory Panel on Federal Tax Reform, Simple, Fair, and
Pro-Growth: Proposals to Fix America's Tax System, (Washington, D.C.:
November 2005).
3GAO, Understanding the Tax Reform Debate: Background, Criteria, &
Questions, GAO-05-1009SP (Washington, D.C.: September 2005).
Background
4GAO-05-1009SP.
The United States Faces a Large and Growing Structural Budget Deficit
Revenues from the Current Tax System Are Not Sufficient to Fund Projected
Spending
Figure 2: Composition of Federal Spending as a Share of GDP, Assuming
Discretionary Spending Grows with GDP after 2006 and That Expiring Tax
Provisions Are Extended
Note: The revenue projection in this figure includes certain tax
provisions that expired at the end of 2005, such as the increased
alternative minimum tax exemption amount.
We cannot grow our way out of this long-term fiscal challenge because the
imbalance between spending and revenue is so large. We will need to make
tough choices using a multipronged approach: (1) revise budget processes
and financial reporting requirements; (2) restructure entitlement
programs; (3) reexamine the base of discretionary spending and other
spending; and (4) review and revise tax policy, including tax expenditures
and tax enforcement programs. Individual income tax policy, tax
expenditures, and enforcement need to be key elements of the overall tax
review.
One promising-and perhaps necessary-approach to tackling both the tax and
entitlements part of our long-term fiscal challenge is a credible,
capable, and bipartisan Tax and Entitlements Reform Commission. Such an
approach would help ensure that any decisions made on taxes and spending
are well coordinated and will produce a sustainable fiscal system that
meets agreed-upon objectives.
The Individual Income Tax Is the Largest Single Source of Federal Revenues
The individual income tax has long been the single largest source of
federal tax revenue. In 2005, individual taxpayers paid $927 billion in
income taxes. Figure 3 shows the relative importance of federal taxes.
Since 1962, the individual income tax has ranged between a low of 7
percent (in 2004) and a high of 10.3 percent (in 2000) of gross domestic
product (GDP). Over the same period, social insurance taxes have grown
considerably in importance-from 3 percent of GDP in 1962 to 6.5 percent of
GDP (or $794 billion) in 2005. Revenue from the individual income tax has
historically accounted for between 40 percent and 50 percent of total
federal tax revenue. In contrast, in the early 1960s, social insurance
taxes accounted for less than 20 percent of the total; however, they have
grown to represent 37.1 percent of revenue in 2005.
Figure 3: Federal Revenues as a Percentage of GDP, 1962 to 2005
Individual Income Tax Complexity, Compliance, and Efficiency Costs and Equity
Concerns Contribute to Calls for Reform
Concerns about the complexity, efficiency, and equity of the individual
income tax have motivated calls for a substantial restructuring of the tax
or its replacement with some form of consumption tax. The widely
recognized complexity of the tax results in (1) significant compliance
costs, frustration, and anxiety for taxpayers; (2) decreased voluntary
compliance; (3) increased difficulties for IRS in administering the tax
laws; and (4) reduced confidence in the fairness of the tax. The
individual income tax also causes taxpayers to change their work, savings,
investment, and consumption behavior in ways that reduce their
well-being.5 These reductions in well-being, known to economists as
efficiency costs, are likely to be large-perhaps on the order of 2 percent
of GDP or more. The success of our tax system hinges very much on the
public's perception of its fairness and transparency. There are
differences of opinion about the overall fairness of the individual income
tax and concerns have been expressed about the equity of many specific
features of the tax.
Important Sources of Complexity Are Income Documentation Requirements and Tax
Expenditure Rules
If they are to take advantage of the many tax benefits in the tax code,
virtually all taxpayers 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). Moreover, in cases where
multiple tax expenditures have similar purposes, taxpayers may have to
devote considerable time to learn and plan in order to make optimal use of
these tax benefits. For example, the IRS publication Tax Benefits for
Education6 outlines 12 tax expenditures, including 4 different tax
expenditures for educational saving. The use of one of these tax
expenditures can affect whether (or how) a taxpayer is allowed to use the
other tax expenditures. Adding to the taxpayer's challenge to select the
best educational tax benefit, 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.7
5GAO-05-1009SP.
6Department of the Treasury, IRS, Publication 970, Tax Benefits for
Education, 2004.
The tax benefits, or tax expenditures, available under the income tax are
usually justified on the grounds that they promote certain social or
economic goals. They grant special tax relief (through deductions,
credits, exemptions, etc.) that encourages certain types of behavior by
taxpayers or aids taxpayers in certain circumstances. Tax expenditures can
promote a wide range of goals, like encouraging economic development in
disadvantaged areas, financing postsecondary education, or stimulating
research and development. For example, a wide range of tax provisions are
intended to help individuals save for their retirement. These include
traditional and Roth Individual Retirement Accounts (IRA) and various
plans administered by employers or available to self-employed individuals.
Again, individuals face complex choices to select the best options as well
as complex rules to stay in compliance once they select a retirement
savings option. From a public policy perspective, all of this complexity
and the burden it imposes on taxpayers would most likely be worthwhile if
the tax incentives are successful in achieving their intended purposes.
However, in many cases this is questionable or unknown. Although research
results vary, many studies suggest that IRAs result in little actual
increase in retirement saving. One concern is that individuals can take a
lump sum withdrawal and, depending on how the sum is used, the individual
may not have a sufficient stream of income over his/her remaining
lifetime.
Tax Expenditures Have Been Growing
The sum of the revenue loss estimates associated with tax expenditures was
more than $775 billion in 2005 and the vast majority of this loss was for
tax expenditures provided to individuals, rather than to corporations.8 As
the data in figure 4 indicate, revenue losses due to tax expenditures
exceeded discretionary spending for half of the last decade.
7Three of the tax incentives for saving-Coverdell Education Savings
Accounts, Qualified Tuition Programs, and U.S. education savings
bonds-differ across more than a dozen dimensions. Similarly, three 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. For a fuller discussion, including estimates of the number of
taxpayers who made suboptimal choices in selecting among three tax
provisions, 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).
8Summing the individual tax expenditure estimates is useful for gauging
the general magnitude of the federal revenue involved, but it does not
take into account possible interactions between individual provisions.
Figure 4: Trends in Spending and Tax Expenditure Revenue Losses, 1982-2005
Note: Summing the individual tax expenditure estimates is useful for
gauging the general magnitude of the federal revenue involved, but it does
not take into account possible interactions between individual provisions.
Much of the revenue loss due to individual income tax expenditures is
attributable to a small number of large tax expenditures. The seven tax
expenditures shown in figure 5-each with an annual revenue loss estimated
at $36 billion or more-accounted for about half of the sum of revenue
losses for all tax expenditures for fiscal year 2005. With revenue losses
estimated at $4.9 billion, the earned income tax credit (EITC) does not
appear on this list. The EITC has both revenue losses and outlays when a
taxpayer's refund exceeds their tax liability. If $34.6 billion in
associated outlays were included, this refundable credit would rank among
the largest tax expenditures.
Figure 5: Revenue Loss Estimates for the Seven Largest Reported Tax
Expenditures for Individuals, Fiscal Year 2005
aIf the payroll tax exclusion were also counted here, the total tax
expenditure for employer contributions for health insurance premiums would
be about 50 percent higher or $177.6 billion.
bThis is the revenue loss and does not include associated outlays of $14.6
billion.
Although Difficult to Measure, Compliance Burden Is Likely a Significant Cost to
Taxpayers
The costs of complying with the individual income tax are large but
unclear. IRS's most recent estimates suggest that these costs are roughly
on the order of 1/2 to 1 percent of GDP. These costs include the time and
money spent complying with 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.
The available compliance cost estimates do not represent the potential
cost savings to be gained by replacing the current federal individual
income tax. 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 child tax credit, which 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 individuals to compute and document their
incomes, 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.
Taxes Generally Reduce Economic Efficiency
Taxes impose efficiency costs by altering taxpayers' behavior, inducing
them to shift resources from higher valued uses to lower valued uses in an
effort to reduce tax liability. This change in behavior can cause a
reduction in taxpayers' well-being that, for example, may include lost
production (or income) and consumption opportunities. One important
behavioral change attributable to the income tax arises from the fact that
investment in housing is given more favorable treatment than investment in
business activities. Economists generally agree that this differential tax
treatment reduces the amount of money available to businesses for
investment in productivity-enhancing technology. This in turn results in
employees receiving lower wages because increases in wages are generally
tied to increases in productivity. The tax exclusion for the exclusion of
employer-provided health insurance from individuals' taxable income,
discussed in text box 1, is another example of an income tax provision
that clearly reduces economic efficiency. The exclusion encourages more
extensive insurance coverage, but introduces a well-known problem with
health insurance. Because much of the cost of medical treatment is paid
for by the insurer, patients and doctors are generally unaware of, or
disconnected from, the total costs of health care and have little
incentive to economize on health care spending.
Efficiency costs, along with the tax liability paid to the government and
the costs of complying with tax laws, are part of the total cost of taxes
to taxpayers. However, this does not mean that taxes are not worth paying.
One reason people bear taxes is they desire the benefits of government
programs and services. (The government does deliver some services
effectively and often provides services that otherwise would not be
available.) Taxpayers implicitly or explicitly balance the costs of taxes
with the benefits of government.
Nevertheless, minimizing efficiency costs is one criterion for a good tax.
Economists agree that taxes with broad bases and low rates generally cause
lower efficiency costs than do taxes with narrow bases and high rates. The
goal of tax policy is to design a tax system that produces revenue needed
to pay current bills and deliver on future promises while at the same time
balancing economic efficiency with other objectives, such as equity,
simplicity, transparency, and administrability. Moreover, as noted
earlier, the failure to provide sufficient tax revenues to finance the
level of spending we choose as a nation gives rise to deficits and debt.
Large, sustained deficits could ultimately have a negative impact on
economic growth, productivity, and potentially our national security.
Large structural deficits also raise serious stewardship and
intergenerational equity issues.
Efficiency Costs Resulting from the Individual Income Tax Are Likely to Be Large
but Can Only Be Estimated with Considerable Uncertainty
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 on how individuals and businesses
change their behavior in response to tax rules. 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.
Text Box 1: Tax Expenditure for Employer-Provided Medical Insurance
Premiums and Medical Care
The current U.S. tax system excludes employer-provided health insurance
from individuals' taxable income even though such insurance is a form of
income (noncash compensation). The Department of the Treasury estimates
that the tax exclusion for employer-provided health insurance resulted in
$118.4 billion in lost revenue during 2005, not including forgone social
insurance taxes and state taxes. Including forgone federal social
insurance taxes, an estimated $177.6 billion in revenue was forgone due to
this exclusion.
The tax exclusion increases the proportion of the population covered by
health insurance. In 2004, nearly 46 million Americans were without health
insurance. The tax exclusion encourages employers to offer and employees
to participate in health insurance plans, increasing the proportion of
workers covered. Because individuals may be better able to anticipate
their health care needs than insurers, health care plans may attract
customers with higher risk of poor health, resulting in higher premiums.
By encouraging the pooling of high-and low-risk individuals, the tax
exclusion may help to reduce premiums below those that individuals would
face if they purchased insurance on their own.
However, some question whether the tax subsidy for health insurance is the
best way to increase health insurance coverage. For example, the tax
exclusion provides the most assistance to taxpayers who have high marginal
tax rates (those with high incomes)-the exclusion saves those taxpayers
more in taxes owed than it saves those with lower marginal tax rates.
The tax exclusion for health insurance also contributes to higher health
care costs. The exclusion, by lowering premiums, encourages more extensive
insurance coverage, which compounds another well-known problem with health
insurance. Because much of the cost of medical treatment is paid for by a
third party (the insurer), patients and doctors are generally unaware of,
or disconnected from, the total costs of health care and have little
incentive to economize on health care spending.
Unlike the tax exclusion for employer-provided health insurance, an ideal
health care payment system would foster the delivery of care that is both
effective and efficient, resulting in better value for the dollars spent
on health care.
The two studies that have made the most comprehensive estimates of the
efficiency costs arising from the individual income tax in the past two
decades suggest that those costs are considerable. The first study, which
examined the combined efficiency costs of the individual income and
payroll taxes, estimated those costs to have been on the order of 2 to 5
percent of GDP in 1994.9 Estimates from the second study indicate that the
efficiency cost of the individual income tax was on the order of 2 percent
of GDP in 1997.10 Efficiency cost estimates such as these are often quite
sensitive to the assumed magnitude of key behavioral 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 the first study assumed them to be.
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.
Perceptions of Inequities in the Tax System Can Undermine Its Success
The success of our tax system hinges very much on the public's perception
of its fairness and transparency. The myriad of tax deductions, credits,
special rates, and so forth cause taxpayers to doubt the fairness of the
tax system because they do not know whether those with the same ability to
pay actually pay the same amount of tax. Fairness is ultimately a matter
of personal judgment about issues such as how progressive tax rates should
be and what constitutes ability to pay.
9Martin Feldstein, "Tax Avoidance and the Deadweight Loss of the Income
Tax," The Review of Economics and Statistics (1999).
10Dale Jorgenson and Kun-Young Yun, Investment Volume 3: Lifting the
Burden: Tax Reform, the Cost of Capital, and U.S. Economic Growth
(Cambridge, Ma.: MIT Press), 2001.
Public confidence in the nation's tax laws and tax administration is
critical because we rely heavily on a system of voluntary compliance. If
taxpayers do not believe that the tax system is credible, easy to
understand, and treats everyone fairly, then voluntary compliance is
likely to decline. The latest available IRS estimates indicate that about
84 percent of total taxes due for tax year 2001 were paid voluntarily and
on time. Complexity and the lack of transparency it can create exacerbate
doubts about the current tax system's fairness.
There are differences of opinion about the fairness of the individual
income tax. Likewise, concerns have been expressed about the equity of
many specific features of the tax, such as:
o marriage penalties (and bonuses) built into the tax under which
the combined tax liabilities of two individuals differ, depending
on whether or not those individuals are married;
o the inconsistent treatment between taxable wages and salaries
and other components of total employee compensation, such as
employer-provided health benefits that are not taxed;
o the fact that many low-income individuals face high effective
marginal tax rates over certain income ranges as the benefits of
tax preferences, such as the earned income tax credit, phase out;
o the provision of certain tax benefits in the form of
deductions, which are more valuable to taxpayers in higher income
brackets, rather than as tax credits;
o the requirement that a taxpayer must own a home in order to
receive the significant advantage of tax-preferred borrowing; and
o the greater ease with which self-employed individuals can
underreport income, compared to employees whose incomes are
subject to withholding and third-party reporting.
Judging the equity of the individual income tax can depend
substantially on the frame of reference used. For example, for
many, a progressive tax code is considered to be more equitable.
When looked at in isolation, the individual income tax system is
somewhat progressive. If the frame of reference is expanded,
however, and payroll taxes are also taken into account, total
progressivity drops.11 As mentioned earlier, more than 70 percent
of taxpayers are estimated to pay more in payroll taxes than
individual income taxes when the combined employee and employer
shares are considered.12 These frames of reference, of course,
look only at the payment of taxes. An even wider frame of
reference would take into account the benefits taxpayers receive,
which could alter yet again judgments about the equity of the tax
system. In fact, it could be argued that the full effect of
federal government policies on different groups of individuals can
only be determined by examining the effects of all federal taxes,
spending programs, and regulations.
Ensuring Individual Taxpayer Compliance with the Tax Laws Is Challenging
The extent of individual taxpayer noncompliance with the current
tax laws is another factor that could motivate calls for reform.
Ensuring compliance with our nation's tax laws is a challenging
process for both taxpayers and IRS. The difficulty in ensuring
compliance is underscored by the tax gap-the difference between
the taxes that should be paid voluntarily and on time and what is
actually paid-that arises every year when taxpayers fail to comply
fully with the tax laws. Most recently, IRS estimated the gross
tax gap for tax year 2001 to be $345 billion, including individual
income, corporate income, employment, estate, and excise taxes.
IRS estimated it would eventually recover about $55 billion of the
gross tax gap through late payments and enforcement actions,
resulting in a net tax gap of $290 billion.13
About 70 percent of the gross tax gap for tax year 2001, or an
estimated $244 billion, was attributed to the individual income
tax. As shown in table 1, individual taxpayers that underreported
their income, underpaid their taxes, or failed to file an
individual tax return altogether or on time (nonfiling) accounted
for $197 billion, $23 billion, and $25 billion of the tax gap,
respectively.
Table 1: Individual Income Tax Portion of the Tax Year 2001 Gross
Tax Gap Estimate
Source: IRS.
Note: Figures may not sum to totals because of rounding.
Improving compliance and reducing the tax gap would help improve
the nation's fiscal stability. Even modest progress would yield
significant revenue; each 1 percent reduction would likely yield
nearly $3 billion annually. However, the tax gap has been a
persistent problem in spite of a myriad of congressional and IRS
efforts to reduce it, as the rate at which taxpayers voluntarily
comply with our tax laws has changed little over the past three
decades. As such, we need to consider not only options that have
been previously proposed but also explore new and innovative
approaches to improving compliance including fundamental reform of
the tax system as well as providing IRS with additional
enforcement tools and ensuring that significant resources are
devoted to enforcement.
Fundamentally reforming our tax system has the potential to
improve compliance, especially if a new system has few tax
preferences or complex tax code provisions and if taxable
transactions are transparent to tax administrators. One factor
that some believe contributes to the difficulty of achieving
compliance is the complexity of our tax system. The complexity of,
and frequent revisions to, the tax system make it more difficult
and costly for taxpayers who want to comply to do so and for IRS
to explain and enforce tax laws. Complexity also creates a fertile
ground for those intentionally seeking to evade taxes, and often
trips others into unintentional noncompliance. Likewise, the
complexity of the tax system challenges IRS in its ability to
administer our tax laws.
Whether under our current income tax system or a reformed one,
enforcement tools, particularly information reporting14 and tax
withholding,15 are key to high levels of compliance. The extent to
which individual taxpayers accurately report the income they earn
has been shown to be related to the extent to which the income is
reported to them and IRS by third parties or taxes on the income
are withheld, as shown in figure 6. Taxpayers tend to report
income subject to tax withholding or information reporting with
high levels of compliance because the income is transparent to the
taxpayers as well as to IRS. For example, employers report most
wages, salaries, and tip compensation to employees and IRS through
Form W-2. Also, banks and other financial institutions provide
information returns (Forms 1099) to account holders and IRS
showing the taxpayers' annual income from some types of
investments. Findings from IRS's recent study of individual tax
compliance indicate that nearly 99 percent of these types of
income are accurately reported on individual tax returns. For
types of income for which there is little or no information
reporting, individual taxpayers tend to misreport over half of
their income.
Figure 6: Individual Net Income Misreporting Categorized by the
Extent of Income Subject to Withholding and Information Reporting
Ensuring that significant resources are devoted to enforcement
also has the potential to minimize the tax gap for our current
income tax system as well as for reformed systems Congress may
adopt. For the current system, devoting more resources has the
potential to reduce the tax gap by billions of dollars in that IRS
would be able to expand its enforcement efforts to reach a greater
number of potentially noncompliant taxpayers. Importantly,
expanded enforcement efforts could reduce the tax gap more than
through direct tax revenue collection, as widespread agreement
exists that IRS enforcement programs have an indirect effect
through increases in voluntary tax compliance.16 However,
determining the appropriate level of enforcement resources to
provide IRS requires taking into account many factors, such as how
effectively and efficiently IRS is currently using its resources,
how to strike the proper balance between IRS's taxpayer service
and enforcement activities, and competing federal funding
priorities.
Generally, when holding IRS accountable for the use of resources,
it is also desirable to focus on the outcomes achieved rather than
on how IRS allocates the resources it receives. Results are really
what counts. If IRS, or any other agency, can figure out how to
more cost effectively achieve a result, then reallocation of
resources to other problem areas could be an appropriate strategy,
within the restrictions applying to appropriation accounts, for
making the best use of limited resources. In sum, regardless of
the tax system, Congress needs to assure itself that the revenue
agency has sufficient resources and reasonable flexibility to
achieve desired outcomes and hold the agency accountable for those
outcomes.
Comparing Proposals on Common Dimensions
In moving forward on tax reform, policymakers may find it useful
to compare proposals on common dimensions. These comparisons can
be helpful whether reform is of the individual income tax, the
current tax system more broadly, or in considering new systems
altogether.
First, is the tax base as broad as possible? Broad-based tax
systems with minimal exceptions have many advantages. Fewer
exceptions generally means less complexity, less compliance cost,
less economic efficiency loss, and by increasing transparency may
improve equity or perceptions of equity. In terms of the
individual income tax, this suggests that eliminating or
consolidating the myriad of tax expenditures must be considered.
We need to be sure that the benefits achieved from having these
special provisions are worth the associated revenue losses just as
we must ensure that outlay programs-which may be attempting to
achieve the same purposes as tax expenditures-achieve outcomes
commensurate with their costs. To the extent tax expenditures are
retained, consideration should be given to whether they are better
targeted to meet an identified need. Many tax expenditures are
broadly available and, in fact, provide greater "assistance" to
those that most would consider least in need. This is broadly true
of any tax expenditure that is worth more to higher income
taxpayers than to lower income taxpayers, like the exclusion for
the value of employer-provided health insurance and the mortgage
interest deduction.
Broad based tax systems can yield the same revenue as more
narrowly based systems at lower tax rates. The combination of less
direct intervention in the marketplace from special tax
preferences, and the lower rates possible from broad based
systems, can have substantial benefits for economic efficiency.
For instance, some economists estimate that the economic
efficiency costs of tax increases rise proportionately faster than
the tax rates. In other words, a 50 percent tax increase could
more than double the economic efficiency costs of a tax system.
Does the proposed system raise sufficient revenue over time to
fund our expected expenditures? As I mentioned earlier, we will
fall woefully short of achieving this end if current spending
and/or revenue trends are not altered. The economic efficiency
costs of our current tax system likely will become an even more
important issue as we grapple with the nation's long-term fiscal
challenges. Although we clearly must restructure major entitlement
programs and the basis of other federal spending, it is unlikely
that our long-term fiscal challenge will be resolved solely by
cutting spending. If we must raise revenues, doing so from a broad
base and a lower rate will help minimize economic efficiency
costs.
In this regard, the President's Advisory Panel on Tax Reform has
taken a useful step forward for tax reform, helping, for example,
to focus the debate on specific proposals. Those proposals
incorporate broader bases, with lower rates. However, the Panel
acted within the guidance it was given, and one result is that the
proposed reforms, if implemented as proposed, appear to provide
much less than the necessary revenue to fund expected government
spending. Although we have not evaluated the revenue effects of
these proposals, other respected analysts have and they point to
future revenue yields that would worsen the already difficult
fiscal challenges the nation faces.
Does the proposal look to future needs? Like many spending
programs, the current tax system was developed in a profoundly
different time. We live now in a much more global economy, with
highly mobile capital, and investment options available to
ordinary citizens that were not even imagined decades ago. We have
growing concentrations of income and wealth. More firms operate
multi-nationally and willingly move operations and capital around
the world as they see best for their firms.
Do the revenues for the proposed system hold up in the future? As
an adjunct to looking forward when making reforms, the revenue
consequences of all major tax changes should be estimated well
into the future. Such long-term projections undoubtedly will be
subject to uncertainty, but at the very least we should have the
best estimates possible of whether the revenue trend is likely to
shift up or down over the long-term.
Does the proposed system have attributes associated with high
compliance rates? Because any tax system can be subject to tax
gaps, the administrability of reformed systems should be
considered as part of the debate for change. In general, a
reformed system is most likely to have a small tax gap if the
system has few tax preferences or complex provisions and taxable
transactions are transparent. Transparency in the context of tax
administration is best achieved when third parties report
information both to the taxpayer and the tax administrator.
What transition issues exist and have they been dealt with in an
equitable fashion that minimizes additional complexity and any
adverse effects on the benefits to be gained from the new tax
system? Under the current individual income tax system, citizens
have made fundamental life choices based at least in part on the
incentives in the tax system. For many, the favorable tax
treatment of owner-occupied housing has led to choices to invest
disproportionately in housing. Others have made long-term
investments in tax-favored college savings plans. Thus, changes to
the tax system can materially affect citizens' futures. Still
others make their livings advising taxpayers, helping them
understand tax provisions and complete their tax returns, and
helping them devise investment and other financial plans taking
into account current tax rules.
Our publication, Understanding the Tax Reform Debate: Background,
Criteria, and Questions,17 may be useful in guiding policymakers
as they consider tax reform proposals. It was designed to aid
policymakers in thinking about how to develop tax policy for the
21st century. While not designed to break new conceptual ground,
this report brings together a number of topics that tax experts
have identified as those that should be considered when evaluating
tax policy. It attempts to provide information about these topics
in a clear, concise, and easily understandable manner for a
non-technical audience.
Concluding Observations
The problems that I have reviewed today relating to the compliance
costs, efficiency costs, equity and tax gap associated with the
current individual income tax system-many of which arise from the
complex accumulation of tax preferences in that system-would seem
to make an overwhelming case for a comprehensive review and reform
of our tax policy. Further, we live a world that is profoundly
different than when the individual income tax and many of its
provisions were adopted. Despite numerous and repeated calls for
such reform, progress has been slow. One reason why reform is
difficult to accomplish is that the provisions of the tax code
that generate compliance costs, efficiency costs, the tax gap and
inequities also benefit many taxpayers and the individuals and
companies that advise taxpayers and help them with their tax
filing obligations. Reform is also difficult because, even when
there is agreement on the amount of revenue to raise, there are
differing opinions on the appropriate balance among the often
conflicting objectives of equity, efficiency, and
administrability. This, in turn, leads to widely divergent views
on even the basic direction of reform.
Fiscal necessity, prompted by the nation's unsustainable fiscal
path, will eventually force changes to our spending and tax
policies. We must fundamentally rethink policies and everything
must be on the table. Tough choices will have to be made about the
appropriate degree of emphasis on cutting back federal programs
versus increasing tax revenue.
Tax reform, if it broadens the tax base, could reduce the costs of
raising a given amount of revenue by reducing the associated
efficiency costs. Such a reform also likely would reduce
inequities, compliance burden, and administrative costs. The
recent report of the President's Advisory Panel on Federal Tax
Reform recommended two different tax reform plans. Although each
plan provides for significant simplification, neither of them
addresses the growing imbalance between federal spending and
revenues that I highlighted earlier. One approach for getting the
process of comprehensive fiscal reform started would be through
the establishment of a credible, capable, and bipartisan
commission, to examine options for a combination of entitlement
and tax reform.
As policymakers consider proposals to reform the current
individual income tax, or the entire tax system, they may find it
useful to compare the proposals on common dimensions. Our
publication, Understanding the Tax Reform Debate, may be useful
when making these comparisons.
Mr. Chairman and Members of the Committee, this concludes my
statement. I would be pleased to answer any questions you may have
at this time.
Contact and Acknowledgments
For further information on this testimony please contact James
White on (202) 512-9110 or [email protected] . Contact points for our
Offices of Congressional Relations and Public Affairs may be found
on the last page of this testimony. Individuals making key
contributions to this testimony include Michael Brostek, Director;
Kevin Daly and Jim Wozny, Assistant Directors; Jeff Arkin;
Elizabeth Fan; Tom Gilbert; Don Marples; and Jeff Procak.
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Ensuring Individual Taxpayer Compliance with the Tax Laws Is Challenging
11Although it makes sense to consider the significant additional burden of
social insurance taxes when evaluating individual tax burdens, there is
some disagreement regarding the proper way to analyze the two taxes
jointly. Many economists consider the portion of payroll taxes that fund
Old-Age and Survivors Insurance benefits to be materially different from
other federal taxes because individuals receive future benefits that are
directly related to the amount of tax they pay. In their view some account
should be made of the redistributive nature of the social security
benefits formula. (See, for example, Richard V. Burkhauser and John A.
Turner, "Is the Social Security Payroll Tax a Tax?," 13 Public Finance
Quarterly, (1985) and Andrew Mitrusi and James Poterba, "The Distribution
of Payroll and Income Tax Burdens, 1979-99," National Tax Journal, Vol. 53
no. 3 Part 2 (September 2000) pp. 765-794.) Other observers assert that
future benefits are an entitlement based on participation in the
workforce, not on the payment of tax, and that all social insurance taxes
should be treated the same as individual income taxes when analyzing the
distribution of tax burdens. (See Patricia E. Dilley, "Taking Public
Rights Private: The Rhetoric and Reality of Social Security
Privatization," Boston College Law Review, 975 (2000) and Deborah A.
Geier, "Integrating the Federal Tax Burden on Labor Income," Tax Notes,
January 27, 2003), pp. 563-583.)
12The Tax Policy Center, using its tax simulation model, has estimated
that 96 percent of taxpayers pay more in payroll taxes than individual
income taxes when both the employee and employer shares of taxes are
considered. Economists widely agree that the employee bears the full
amount of the payroll tax.
Type of noncompliance Tax gap (dollars in billions)
Underreporting $197
Business income 109
Nonfarm proprietor income 68
Partnership, S-Corp, estate and trust 22
Rents & royalties 13
Farm income 6
Nonbusiness income 56
Capital gains 11
Wages, salaries, tips 10
Pensions and annuities 4
Interest and dividend income 3
Other 28
Credits 17
Deductions, exemptions, adjustments 15
Underpayment 23
Nonfiling 25
Total $244
13Unless otherwise noted, references to the tax gap refer to the gross tax
gap.
14Information reporting involves the filing of information returns with
IRS and taxpayers that contain information on certain transactions, such
as wage and salary information employers report to employees and IRS
through Form W-2.
15An example of tax withholding is when employers withhold taxes on the
wages that employees earn and remit them to IRS.
Comparing Proposals on Common Dimensions
16Two types of indirect effect are (1) the increase in voluntary
compliance in the larger population resulting from examinations or other
enforcement and nonenforcement actions on targeted taxpayers, and (2) the
increase in voluntary compliance of the targeted taxpayer in subsequent
years.
17 GAO-05-1009SP .
Concluding Observations
Contact and Acknowledgments
(450509)
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Highlights of GAO-06-1028T , a testimony before the Committee on Finance,
U.S. Senate
August 3, 2006
INDIVIDUAL INCOME TAX POLICY
Streamlining, Simplification, and Additional Reforms are Desirable
The federal government currently relies heavily on the individual income
tax and payroll taxes for about 80 percent of its total annual revenue.
Long-range projections show that without some form of policy change, the
gap between revenues and spending will increasingly widen. The debate
about the future tax system is partly about whether the goals for the
nation's tax system can be best achieved by reforming the current income
tax so that it has a broader base and flatter rate schedule, or switching
to some form of consumption tax.
This testimony reviews the revenue contribution of the current individual
income tax as well as its complexity, economic efficiency, equity, and
taxpayer compliance issues; discusses some common dimensions to compare
tax proposals; and draws some conclusions for tax reform.
This statement is based on previously published GAO work and reviews of
relevant literature.
The United States faces a large and growing structural budget deficit as
current projected revenues are not sufficient to fund projected spending.
The individual income tax has long been the largest source of federal
revenue-amounting to $927 billion (7.5 percent of Gross Domestic Product
(GDP)) in 2005. (Total revenues that year amounted to 17.5 percent of
GDP.) Income tax policy, including existing tax expenditures, such as the
exclusion of employer-provided health insurance from individual income,
and enforcement approaches, need to be key elements of a multipronged
approach that reexamines federal policies and approaches to address our
nation's large and growing long-term fiscal imbalance.
Concerns regarding the complexity, efficiency, and equity of the
individual income tax have contributed to calls for a substantial
restructuring of the individual income tax or its full or partial
replacement with some form of consumption tax. The widely recognized
complexity of the tax results in (1) significant compliance costs,
frustration, and anxiety for taxpayers; (2) decreased voluntary
compliance; (3) increased difficulties for the Internal Revenue Service
(IRS) in administering the tax laws; and (4) reduced confidence in the
fairness of the tax. The tax also causes taxpayers to change their work,
savings, investment, and consumption behavior in ways that reduce economic
efficiency and, thereby, taxpayers' well-being.
Taxpayer noncompliance with the current individual income tax is another
factor that could motivate reform. For tax year 2001, IRS estimated that
noncompliance with the individual income tax accounted for about 70
percent of the $345 billion gross tax gap, which is the difference between
the taxes that should have been paid voluntarily and on time and what was
actually paid. Reducing this gap can improve the nation's fiscal
stability, as each 1 percent reduction in the tax gap would likely yield
about $3 billion annually. Reducing the tax gap within the current income
tax structure will require exploring new and innovative administrative and
legislative approaches.
In moving forward on tax reform, policymakers may find it useful to
compare alternative proposals along some common dimensions. These include,
in part, whether proposed tax systems over time will generate enough
revenue to fund expected expenditures, whether the base is as broad as
possible so rates can be as low as possible, whether the system meets our
future needs, and whether it has attributes that promote compliance. Our
publication, Understanding the Tax Reform Debate (GAO-05-1009SP), provides
background, criteria, and questions that policymakers may find useful.
*** End of document. ***