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The Rising Cost of Complying with the Federal Income Tax by J SPECIAL December 2005 No. 138 REPORT The Rising Cost of Complying with the Federal Income Tax by J. Scott Moody, M.A. Executive Summary Adjunct Scholar In 2005, taxpayers will pay roughly $1.2 taxpayer, income level and state. In 2005, Wendy P. Warcholik, Ph.D. trillion in federal income taxes. But America’s businesses will bear the majority of tax compli- Adjunct Scholar tax burden is more than just the amount of tax ance costs, totaling nearly $148 billion or 56 paid. It also includes the cost of complying percent of total compliance costs. Compliance Scott A. Hodge President with federal taxes, including tax planning, pa- costs for individuals will be $111 billion or 42 Tax Foundation perwork and other hassles caused by tax percent, and non-profits will bear nearly $7 complexity. billion or 2.5 percent of the total. In the last century the cost of tax compli- When examined by income level, compli- ance has grown tremendously. This is due ance cost is found to be highly regressive, partly to the inherent difficulty of taxing in- taking a larger toll on low-income taxpayers as come, but also because of growing a percentage of income than high-income tax- non-economic demands lawmakers place on payers. On the low end, taxpayers with the tax code. As Congress debates the tax re- adjusted gross income (AGI) under $20,000 form recommendations of the President’s incur a compliance cost equal to 5.9 percent of Advisory Panel on Federal Tax Reform, Mem- income while the compliance cost incurred by bers should address this growing compliance taxpayers with AGI over $200,000 amounts to burden, and work to reduce it through tax sim- just 0.5 percent of income. plification and reform. State-by-state estimates of the 2005 federal In 2005 individuals, businesses and non- compliance cost also vary widely because state profits will spend an estimated 6 billion hours populations and economies differ so signifi- complying with the federal income tax code, cantly. On a per capita basis, Wyoming with an estimated compliance cost of over ($1,242), Delaware ($1,181) and Colorado $265.1 billion. This amounts to imposing a ($1,167) face the highest compliance cost 22-cent tax compliance surcharge for every while Mississippi ($658), West Virginia dollar the income tax system collects. Projec- ($689), and Tennessee ($705) face the lowest. tions show that by 2015 the compliance cost Measured per $1,000 of income, Montana will grow to $482.7 billion. (See Table 1 and ($38), Utah ($37), and Wyoming ($33) face Figures 1 and 2). the highest compliance cost while California ($19), Connecticut ($20) and Massachusetts The burden of tax compliance does not ($21) face the lowest. fall evenly on taxpayers. It varies by type of SPECIAL 2 REPORT Why Compliance Costs Matter two general types of economic costs: overhead It is important for taxpayers to have an es- costs and opportunity costs. timate of their compliance cost because the performance of the economy is dramatically The Cost of Overhead affected by the level of complexity in tax law. If Overhead costs of a tax system can be di- lawmakers create an Internal Revenue Code vided into three activities: tax planning, that is unnecessarily complex or that changes litigation, and compliance all of which are eco- rapidly, taxpayers will face uncertainty about nomically sterile activities that act like tax how taxes will affect a business plan or invest- surcharges on taxpayers. ment. When the tax consequences of economic • Tax planning refers to all the economic activities are unpredictable, tax policy handi- decisions that individuals and firms make caps the growth and dynamism of the U.S. to minimize their tax liabilities under economy. current law. Studies of the federal income tax code con- • Tax audits and litigation refer to the eco- sistently find that the current system is nomic cost of the IRS and the Tax excessively complex. This study concurs, quan- Court, including the legal costs that tax- tifying the code’s complexity in a way that payers incur while dealing with these two makes clear how unnecessary much of it is. If government institutions. the high cost of complying with the federal in- come tax were a necessary price to pay for a fair • Tax compliance refers to the basic actions and effective tax system, there would be little required to file federal income tax re- room for complaint. But in fact, most com- Table 1 plaints are justified. Total Federal Income Tax Compliance Costs Calendar Years 1990–2015 Measuring the Cost of Compliance Real Percent of The complexity generated by the growth Current 2005 Federal and constant change of the tax code creates Dollars Dollars Revenue 1990 $79.7 $107.6 14.1% Figure 1 1991 $85.1 $111.0 15.5% Total Federal Income Tax Compliance Costs 1992 $94.7 $120.7 16.4% 1990–2015 1993 $102.2 $127.4 16.3% $500 1994 $106.0 $129.3 15.6% 1995 $112.2 $134.2 15.1% 1996 $120.3 $141.2 14.4% $400 1997 $128.5 $148.4 13.9% 1998 $143.4 $163.8 14.3% 1999 $162.6 $183.1 15.0% $300 2000 $172.9 $190.5 14.5% 2001 $181.1 $194.9 16.0% Billions $ 2002 $207.7 $219.8 21.7% $200 2003 $232.5 $241.6 24.8% 2004 $243.9 $248.3 24.4% $100 2005p $265.1 $265.1 22.2% 2006p $278.6 $274.4 21.9% 2007p $305.3 $295.8 22.8% $0 2008p $325.7 $310.0 23.0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005p 2006p 2007p 2008p 2009p 2010p 2011p 2012p 2013p 2014p 2015p 2009p $346.9 $324.3 22.9% 2010p $368.4 $338.3 22.8% 2011p $391.9 $353.7 21.5% Calendar Year 2012p $409.5 $363.1 20.7% Real 2005 Dollars Current Dollars 2013p $432.7 $376.9 20.7% 2014p $457.2 $391.1 20.7% Source: Internal Revenue Service, Tax Foundation calculations. 2015p $482.7 $405.8 20.7% SPECIAL 3 REPORT turns, including record keeping, educa- income taxes. In the absence of withholding, tion, form preparation and packaging/ taxpayers could have conservatively invested sending. this money in U.S. Treasury Bonds. In 2004, the average rate of return on a 10-year U.S. Of these three costs, tax compliance is the security was 4.3 percent.1 Assuming the same only one estimated in this report. It is for this rate for 2005, taxpayers could pocket $24.8 reason that the data presented here should be billion in interest payments over the course of viewed as extremely cautious estimates of tax- the year. In reality, the federal government col- payers’ federal income tax compliance cost. lects the withheld income tax payments and uses it to fund current operations. Therefore, Opportunity Costs the forgone interest represents a significant op- The second general type of economic cost portunity cost of federal taxes. caused by the tax system is opportunity cost. Opportunity costs are the lost value activities However, many opportunity costs of the that are displaced by the tax system. For exam- tax code are more difficult to quantify. For ex- ple, wage-earners are currently required to have ample, consider a software developer who federal income taxes withheld from their pay- spends considerable time complying with the checks, in essence, forcing taxpayers to prepay tax code. That time may have instead been their income taxes. As a result, they forgo the spent working on new ideas that could poten- economic returns (interest, profit, dividends, tially blossom into profitable new products and etc.) they might have generated with this in- services, creating billions of dollars of wealth. come between the time of withholding and the Every hour or dollar spent complying with the time when taxes are actually due. This lost val- tax code represents resources that could have ue is the opportunity cost of federal been spent tending to business problems, add- withholding, and represents a real economic ing value to the U.S. economy. Unfortunately, cost of the tax system. because of the difficulty of quantifying these forgone economic activities, this study underes- In 2005, the federal government is esti- timates the true opportunity costs of the tax mated to collect $1.2 trillion in individual system, potentially by a large amount. Figure 2 What Causes Tax Complexity and Federal Income Tax Compliance Costs as a Percentage of Revenue 1990–2015 Compliance Costs? In 1927 the Joint Committee on Internal 26% Revenue Taxation reported, “It must be recog- nized that while a degree of simplification is 24% possible, a simple income tax for complex busi- 22% ness is not.” This is certainly true of business income, but almost equally true of individual 20% income as currently defined. 18% The inherent complexity of any income tax Percent results from the difficulty of defining income 16% and determining when and to whom to recog- 14% nize income and expense for tax purposes. Over time, the political process of give-and- 12% take has made these questions of how to define the tax base inordinately complex. The defini- 10% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005p 2006p 2007p 2008p 2009p 2010p 2011p 2012p 2013p 2014p 2015p tion of taxable income has not only expanded dramatically, but it has undergone chronic change. Calendar Year Adding to the inherent complexities of tax- Source: Congressional Budget Office, Tax Foundation.
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