In The Hidden Cost of Federal Tax Policy, Jason Fichtner and Jacob Feldman survey the chief culprits behind flawed tax policy and offer key principles for successful reform. Although not entirely focused on the world of regulation, the ancillary components of current policy help to generate the 200 forms and 2.6 billion work hours associated with the individual income tax and the 235 forms and 2.8 billion work hours for the business income tax. Fundamental tax reform could save the nation billions of hours of paperwork and tens of billions of dollars in monetary savings. Broken tax policy is more than just a conversation about what is taken from a paycheck; it concerns what is taken from an economy.

Estimating hidden costs / Unsurprisingly, there are varying estimates for the benefits from reforming different components of federal tax policy. The authors highlight how one component, accounting costs, is driven largely by the more than 4,000 changes to the code from 2001 and 2010, including 579 in 2010. This accounting slate is responsible for between $67 billion and $378 billion in annual burdens. For what it’s worth, the Internal Revenue Service estimates the individual income tax costs $33.6 billion for Americans to navigate annually. Astonishingly, there is no estimate for the monetary burdens imposed by the business income tax, even though it generates more paperwork and more forms.

The second hidden cost lies in the infamous “Tax Gap.” This is the difference between the revenue the IRS is permitted to collect by law and what it actually collects. The authors note the Tax Gap is roughly $450 billion—that is, clever (or deceptive) accounting results in nearly a half-trillion-dollar underpayment. Why should the average taxpayer care about the IRS’s Tax Gap? For one, it creates a social cost of inequitable tax burdens among some taxpayers; those with more creative accountants and lobbyists tend to help create the gap.

Finally, there are the economic costs of a broken tax system. Again, estimates here vary wildly, between $148 billion and $609 billion. As former Supreme Court Chief Justice John Marshall noted some 200 years ago, “The power to tax is the power to destroy.” Taxes simply increase the cost of doing business, from buying materials to paying for labor. The wide range for these economic costs derives from the studies over the years trying to find an appropriate figure. On the low-end, Sören Blomquist and Laurent Simula estimated in a 2010 paper the deadweight loss of tax compliance at $148 billion, after accounting for income, payroll, and state income taxes. At the other end, Martin Feldstein estimated $609 billion in deadweight losses with the payroll tax and $388 billion without.

Breaking the code / The authors spend nearly as much time in the book surveying the reasons the tax code is mindlessly broken as they do offering solutions for rational reform. To no one’s surprise, lobbying plays a heavy role in creating tax credits, exemptions, and deductions that Americans end up subsidizing. As the saying goes, “If there is food at the picnic, ants will follow.” Given the size and scope of government, there is always plenty of food.

Fichtner and Feldman note that research reveals intense lobbying is often effective. They write, “Businesses that increased lobbying expenditures by 1 percent reduced their effective tax rates by 0.5 to 1.6 percentage points the following year.” Diffuse costs, concentrated benefits—if only we could all be so well-connected.

This lobbying extravaganza is often led by the plethora of lawyers in Washington, D.C. The authors somewhat gleefully remind the reader that there is a strong negative international correlation between the number of law students and economic growth. Conversely, nations with a high concentration of engineering students tend to have robust economic growth. Regardless, we can all agree that focusing the nation’s attention on producing tax carve-outs, rather than actual production, will do no favors for economic growth.

Who doesn’t take tax breaks / Part of the problem with a government of our size is that it intrudes into virtually every area of life: subsidizing the purchase of a home ($69 billion) and health care ($185 billion), to name just two. Through the years, everyone has become dependent on, or taken advantage of, favorable tax treatment created by the code.

The mortgage interest deduction (MID) is singled-out for special treatment, and rightfully so. If you live near a coast or in a major city, it is likely one of your largest tax breaks; if you don’t, you’re subsidizing large home purchases elsewhere. As the authors note, less than one in 10 Americans earning less than $50,000 can claim the MID. High-income earners net a tax benefit that is nine times larger than tax filers earning between $50,000 and $100,000. Middle-income Americans can thank the real estate industry for this inequity.

And yet, this deduction does little to advance its intended function of promoting home ownership, which is a dubious goal of government in its own right. Instead, the MID encourages more debt and borrowing. Despite the deduction, the United States is nowhere near the top for home ownership rates. That title belongs to Singapore at 87 percent, yet Singapore has no MID. The United States clocks in at 65 percent, slightly lower than the United Kingdom, which also doesn’t have a MID.

Reform / There are a million different proposals for reforming the federal tax code, but Fichtner and Feldman spend just a few words on broad reform principles: simplicity, equity, efficiency, and permanency. In the utopian world where federal tax policy does undergo wholesale reform, expect ancillary regulatory benefits as well. Consider that a 50 percent reduction in the IRS’s paperwork burden would generate roughly 4.5 billion hours in savings. Even assuming a conservative $20 per hour rate for IRS compliance, that would equal $90 billion in annual savings.

Don’t hold your breath for that, unfortunately. Yet, anyone interested in learning the history of the current tax code and surveying its failures would do well to review the work of Fichtner and Feldman.

Readings

  • “Marginal Deadweight Loss when the Income Tax Is Nonlinear,” by Sören Blomquist and Laurent Simula. Uppsala University (Sweden), 2012.
  • “Tax Avoidance and the Deadweight Loss of the Income Tax,” by Martin Feldstein. Review of Economics and Statistics, Vol. 81, No. 4 (1999).