Even the IRS Says the Tax Code has “Overwhelming Complexity”

In the annual report to Congress, released January 7, 2009 by the National Taxpayer Advocate for the IRS, Nina Olson said, “The largest source of compliance burdens for taxpayers, and the IRS, is the overwhelming complexity of the tax code” and “The only meaningful way to reduce these burdens is to simplify the tax code enormously.”

The report – available on line here (The Complexity of the Tax Code) – is a 12 page pdf file. Here is the text of the report without the footnotes and graphs:

Taxpayer Advocate Service — 2008 Annual Report to Congress — Volume One 3
The Complexity of the Tax Code MSP #1
Most Serious Problems #1
The Complexity of the Tax Code
Definition of Problem – The most serious problem facing taxpayers is the complexity of the Internal Revenue Code.
Analysis of Problem – The largest source of compliance burdens for taxpayers – and the IRS – is the overwhelming complexity of the tax code. The only meaningful way to reduce these burdens is to simplify the tax code enormously.
Consider the following:

• According to a TAS analysis of IRS data, U.S. taxpayers and businesses spend about 7.6 billion hours a year complying with the filing requirements of the Internal Revenue Code.2 And that figure does not even include the millions of additional hours that taxpayers must spend when they are required to respond to an IRS notice or an audit.
• If tax compliance were an industry, it would be one of the largest in the United States. To consume 7.6 billion hours, the “tax industry” requires the equivalent of 3.8 million full-time workers.
• Compliance costs are huge both in absolute terms and relative to the amount of tax revenue collected. Based on Bureau of Labor Statistics (BLS) data on the hourly cost of an employee, TAS estimates that the costs of complying with the individual and corporate income tax requirements in 2006 amounted to $193 billion – or a staggering 14 percent of aggregate income tax receipts.
• Since the beginning of 2001, there have been more than 3,250 changes to the tax code, an average of more than one a day, including more than 500 changes in 2008 alone.
• The Code has grown so long that it has become challenging even to figure out how long it is. A search of the Code conducted in the course of preparing this report turned up 3.7 million words.6 A 2001 study published by the Joint Committee on Taxation put the number of words in the Code at that time at 1,395,000.7 A 2005 report by a tax research organization put the number of words at 2.1 million, and notably, found that the number of words in the Code has more than tripled since 1975.
  Tax regulations, which are issued by the Treasury Department to provide guidance on the meaning of the Internal Revenue Code, now stand about a foot tall.   The CCH Standard Federal Tax Reporter, a leading publication for tax professionals that summarizes administrative guidance and judicial decisions issued under each section of the Code, now comprises 25 volumes and takes up nine feet of shelf space.  Two companies publish newsletters daily that report on new developments in the field of taxation; the print editions often run 50-100 pages and the electronic databases contain substantially more detailed information.
• The complexity of the Code leads to perverse results. On the one hand, taxpayers who honestly seek to comply with the law often make inadvertent errors, causing them either to overpay their tax or to become subject to IRS enforcement action for mistaken underpayments of tax. On the other hand, sophisticated taxpayers often find loopholes that enable them to reduce or eliminate their tax liabilities.
• Individual taxpayers find the return preparation process so overwhelming that more than 80 percent pay transaction fees to help them file their returns. About 60 percent12 pay preparers to do the job,13 and another 22 percent purchase tax software to help them perform the calculations themselves.
• The Code contains no comprehensive Taxpayer Bill of Rights that explicitly and transparently sets out taxpayer rights and obligations.15 Taxpayers do have rights, but they are scattered throughout the Code and the Internal Revenue Manual and are neither easily accessible nor written in plain language that most taxpayers can understand.

The Office of the Taxpayer Advocate sees dozens of examples of the impact of tax law complexity each year. Here are some key illustrations:

• Excessive Number of Education and Retirement Savings Incentives. The Code currently contains at least 11 incentives to encourage taxpayers to save for and spend on education; the eligibility requirements, definitions of common terms, income level thresholds, phase-out ranges, and inflation adjustments vary from provision to provision.17 The Code also contains at least 16 incentives to encourage taxpayers to save for retirement; these incentives are subject to different sets of rules governing eligibility, contribution limits, taxation of contributions and distributions, withdrawals, availability of loans, and portability.18 Taxpayers wishing to choose the optimal vehicle to save for college must know the difference between a Section 529 plan, a Coverdell Education Savings Account, and the Hope and Lifetime Learning Credits, among other alternatives. Taxpayers wishing to choose the optimal plan in which to save for retirement must know the difference between a traditional IRA, a Roth IRA, a Section 401(k) plan, a Section 403(b) plan, and a SARSEP, among others.
  The point of a tax incentive, almost by definition, is to encourage certain types of economic behavior. But taxpayers can only respond to incentives if they know they exist and understand them. Choice is good, but too much choice is overwhelming. It is not reasonable to expect the average taxpayer to learn the details of at least 27 education and retirement incentives to determine which ones provide the best fit.
• The Alternative Minimum Tax (AMT). The AMT concept, originally enacted in response to a report that 155 high-income taxpayers had paid no tax for the 1966 tax year, now effectively requires taxpayers to compute their taxes twice – once under the regular rules and again under the AMT regime – and then to pay the higher of the two amounts.21 The AMT was originally conceived to prevent wealthy taxpayers from escaping tax liability through the use of tax-avoidance transactions. However, most of the significant tax loopholes that enabled taxpayers to escape tax at the time the AMT was written have long since been closed, and it is now estimated that about 77 percent of the additional income subject to tax under the AMT is attributable simply to family size or residing in a high-tax state.22 Few people think of having children or living in a high-tax state as a tax avoidance maneuver, but under the unique logic of the AMT, that is how those actions are treated. Yet government has become so dependent on AMT revenue that Congress to date has been unwilling to make permanent changes in law to curtail the AMT, and it is not likely that such changes will be made outside the context of major tax reform.
• Tax Consequences of Mortgage Foreclosures and Canceled Debts. Most financially distressed individuals who lose their homes to foreclosure or cannot pay off their car loans, credit card balances, student loans, or medical bills probably do not realize that
  their delinquency may increase their tax liabilities, but it often does. If a creditor writes off a debt, the tax code generally treats the amount of the canceled debt as taxable income to the debtor. Congress has carved out a number of exclusions, including a recently enacted exclusion to help homeowners whose mortgage debts are canceled when their houses are foreclosed upon and sold.25 However, taxpayers do not receive the benefit of these exclusions automatically. A taxpayer must file Form 982, Reduction of Tax Attributes Due to Discharge of Indebtedness (and Section 1082 Basis Adjustment), to claim an exclusion. Form 982 is extremely complex, and very few taxpayers or preparers are familiar with it. The IRS estimates that it takes business taxpayers ten hours and 43 minutes to complete the form,26 and the form is not included in many tax software packages available to taxpayers.
  IRS data shows that approximately two million Forms 1099-C, Cancellation of Debt, are issued to taxpayers each year reporting canceled debts.27 The National Taxpayer Advocate estimates that tens of thousands and possibly hundreds of thousands of taxpayers who qualify to exclude canceled debts from gross income do not file Form 982 to claim allowable exclusions. Instead, some of these taxpayers unnecessarily include the amount of the canceled debt in gross income, and other taxpayers who fail to include it unnecessarily face IRS examinations and tax assessments.
• Earned Income Tax Credit (EITC) Complexity. About 22 million low income taxpayers claim the EITC each year.30 The eligibility requirements and computations are complex, yet EITC recipients are relatively less able to understand complex rules and less likely to speak English as their primary language, creating a recipe for confusion. EITC complexity leads to improper claims by taxpayers – some intentional but many inadvertent – and to improper denials by the IRS. A 2004 TAS study surveyed cases in which the IRS denied an EITC claim on audit but the taxpayer asked the IRS to reconsider its findings. Despite the initial IRS denials, the study found that taxpayers ultimately obtained some or all of the EITC amount they had claimed on their returns in 43 percent of the cases (and they received, on average, 94 percent of the amount they had originally claimed). Another window into EITC complexity: One might expect that low income taxpayers would be less likely to need return preparers because their sources of income are often limited to wages and perhaps interest income, yet 72.5 percent of taxpayers who claim the EITC use tax preparers.
• Proliferating Tax Sunsets. The tax code contains more than 100 provisions that are temporary and set to expire soon, up from about 21 in 1992. Tax benefits have increasingly been enacted for a limited number of years in order to reduce their cost for budget-scoring purposes. Although most such benefits are periodically renewed, some are not. For example, the AMT patch and the deductions for state and local taxes and for tuition and fees paid to a post-secondary institution are generally renewed for one or two years at a time, but the extensions are not guaranteed and the amount of the AMT patch is generally changed with each renewal. If taxpayers do not know whether a tax benefit will remain in the Code, the incentive is less likely to influence their decision-making, thereby undermining its purpose. The uncertainty associated with an expiring tax benefit also makes it difficult for taxpayers to estimate their tax liabilities and pay the correct amount of estimated tax, potentially subjecting them to penalties and causing disillusionment with the tax system.
• Phase-out Complexity. More than half of all individual income tax returns filed each year are affected by the phase-out of certain tax benefits. A common phase-out relates to the deduction allowed for personal exemptions. For example, a married couple with two minor children is generally allowed to claim four personal exemptions if they file a joint return, with each deduction worth $3,500 ($14,000 in the aggregate) in tax year 2008.35 If the family’s adjusted gross income (AGI) exceeds a certain threshold, however, the exemption amount is phased out at a rate of two percentage points for each additional $2,500 (or fraction thereof) of income. Thus, under permanent law, the benefits of the personal exemptions would fully phase out over a $125,000 income range. But under a temporary provision that will sunset after 2009, the phase-out is capped at one-third of the exemption amount. Thus, the phase-out may not reduce the exemption amount below $2,333 per family member ($9,332 in the aggregate). This computation is not obvious to the average taxpayer, and as noted, there are about 100 phase-outs that operate in this manner. Like tax sunsets, phase-outs are largely used to reduce the cost of tax provisions for budget-scoring purposes. However, phase-outs add substantial complexity and create marginal “rate bubbles” – income ranges within which an additional dollar of income earned by a relatively low income taxpayer is taxed at a higher rate than an additional dollar of income earned by a relatively high income taxpayer. This inequity is largely hidden by the complexity of the phase-out calculations.
• Unclaimed Telephone Excise Tax Refunds. In 2006, taxpayers were permitted to claim a one-time tax credit for telephone excise taxes that the government concluded it had improperly collected in the past.38 The amount of the credit ranged from $30 to $60, depending on the number of personal exemptions the taxpayer was entitled to claim on the return.39 No substantiation was required unless a taxpayer claimed a larger amount, so this credit was essentially free money. Yet IRS data show that 28 percent of eligible taxpayers (37 million out of 133.2 million) did not claim the credit. The only plausible explanation is that taxpayers missed the credit because of the complexity of the law and the tax forms.
• Burgeoning Penalties. The number of civil penalties in the Code has grown from about 14 in 1954 to approximately 130 today.42 Penalties should be designed to enhance voluntary tax compliance, but they also should be reasonable and can only influence future taxpayer behavior if taxpayers are aware that the penalties exist. As a consequence of “penalty creep,” some penalties are obscure or unduly harsh. For example, Section 6707A of the Code, which was enacted in 2004 to combat tax shelters, imposes a minimum penalty of $100,000 per individual per year and $200,000 per entity per year for a failure to disclose a “listed transaction.”43 The penalty reflects strict liability – the IRS must impose the penalty even if the taxpayer derived little or no tax benefit, even if the taxpayer had no reason to know the transaction was questionable, and even if the transaction was not “listed” until years after the taxpayer’s return was filed and the transaction was complete. Taxpayers cannot challenge this penalty in court. As a result, an individual who does business as an S corporation and who entered into a transaction that he did not know was listed and that provided little or no tax savings would face an automatic $300,000 penalty per year. In addition, the usual three-year statute of limitations on tax assessments does not apply in the case of listed transactions,44 so if the taxpayer entered into a listed transaction that was reflected on his return for ten years, he would face an automatic $3 million penalty overall. TAS has about 40 cases in its inventory involving non-rescindable Section 6707A penalties,45 and we understand the IRS is considering this penalty in hundreds of additional cases. If Congress does not change the law quickly, this penalty may bankrupt middle-class families that had no intention of entering into a tax shelter.
• Small Business Burdens. Small business taxpayers face a particularly bewildering array of laws, including a patchwork set of rules that governs the depreciation of equipment, numerous and overlapping filing requirements for employment taxes, and a vague set of factors that govern the classification of workers as either employees or independent contractors and that can keep businesses and the IRS battling each other for years with no obvious “correct” answer.

Recommendation
The National Taxpayer Advocate recommends that Congress substantially simplify the Internal Revenue Code.

America’s taxpayers deserve a simpler and less burdensome tax system that enables them to comply with their tax obligations expeditiously – not one that requires them to spend 7.6 billion hours filing their returns every year, thereby consuming the equivalent of 3.8 million full-time workers. Taxpayers deserve a tax system that enables them to prepare their returns cheaply – not one that requires them to pay practitioners for help, as nearly 61 percent of individual taxpayers and 74 percent of unincorporated business taxpayers do today. Taxpayers deserve more clarity about their rights and obligations under the tax code in the form of a Taxpayer Bill of Rights. Taxpayers deserve a tax system that enables them to make wise choices about education and retirement savings – without having to wade through the details of at least 27 tax-favored alternatives. Taxpayers deserve a tax system that enables them to compute their tax liabilities fairly and transparently – not one that effectively requires them to compute their tax liability under two sets of rules (the regular rules and the AMT rules) and often to pay more tax under the AMT regime simply because they engaged in the “tax-avoidance behavior” of having children or living in a high-tax state.

Taxpayers deserve better than a tax system so complex that honest taxpayers often overpay while sophisticated taxpayers often find loopholes, and so complex that 37 million taxpayers could fail to claim a tax credit because they did not know it was available. Taxpayers deserve better than a tax system that gives financially distressed taxpayers a tax break when they default on their mortgage or other consumer debts and the debts are canceled – but then makes claiming the tax break so burdensome that many and probably most eligible taxpayers do not claim it. Low income taxpayers deserve a simpler set of rules by which determine EITC eligibility.

Taxpayers deserve certainty about which provisions will remain in the tax code so they can plan accordingly – without having to regularly grapple with uncertainty because more than 100 provisions sunset regularly and may or may not be renewed or modified. Taxpayers deserve to understand exactly how their tax liabilities are computed – not provisions like phase-outs, which make the computations seem impenetrable and subject lower income taxpayers to higher marginal tax rates than upper income taxpayers. Taxpayers deserve simplicity and proportionality in the penalty rules; it is not reasonable that a taxpayer who claims minimal or even no tax savings may face a mandatory, non-waivable $300,000 penalty per year for failing to file a disclosure form that he may not even know he is required to file.

These are a few aspects of a system that requires pervasive reform. The good news is that there is widespread agreement on the need for tax simplification. The National Taxpayer Advocate has previously identified the complexity of the tax code as the most serious problem facing taxpayers, members of Congress regularly complain about the complexity of the Code, and in 2005, an advisory panel created by President Bush to study the federal tax system delivered a detailed report with substantive recommendations. The bad news is that despite widespread agreement on the need for tax simplification, there has not yet been sustained action to make it happen.

To assist the Congress in pursuing tax simplification, we offer a number of proposals in the Legislative Recommendations section of this report, including recommendations to streamline the education and retirement savings incentives, repeal the AMT, allow taxpayers to exclude modest amounts of canceled debts from income without filing Form 982, simplify the family status provisions of the Code, reduce tax sunset and phase-out provisions, and revise the penalty structure.

The National Taxpayer Advocate continues to view tax simplification as essential and urges the new administration and the new Congress to make it a priority. In doing so, she recommends that emphasis be given to six core principles:

1. The tax system should not “entrap” taxpayers.
2. The tax laws should be simple enough so that most taxpayers can prepare their own returns without professional help, simple enough so that taxpayers can compute their tax liabilities on a single form, and simple enough so that IRS telephone assistors can fully and accurately answer taxpayers’ questions.
3. The tax laws should anticipate the largest areas of noncompliance and minimize the opportunities for such noncompliance.
4. The tax laws should provide some choices, but not too many choices.
5. Where the tax laws provide for refundable credits, they should be designed in a way that is administrable; and
6. The tax system should incorporate a periodic review of the tax code – in short, a sanity check.

Be sure and read What is the FairTax? and Herman Cain’s Top Ten Advantages of the FairTax.