The High Cost of Tax Compliance

The federal income tax started in 1913. The instructions to file a return took up 3 pages. In 1945, the instructions for the 1040 income tax form were 4 pages. In 1955, that had quadrupled to 16 pages. By 1985, it had grown to 52 pages. The 2000 instruction book for the 1040 was 117 pages long.

(Source: Associated Press story: “Tax Time More Difficult Than Ever,“ April 13, 2001 / National Taxpayer's Union)

This year’s book will be no smaller in spite of promises from congressmen and senators to simplify the tax system.

This insanity must end. The cost of compliance may soon (if it hasn’t already) eclipse the cost of the tax itself.

A study by economist J. Scott Moody in Tax Foundation Background Paper No. 35 explains that many substantial costs of the overall "compliance burden" are excluded from the government’s estimate of $125 billion annually. For example, the productive value that people may have added to the economy if they had been working instead of filling out forms is excluded because estimating this "opportunity cost" is exceedingly difficult and speculative. The costs of the IRS, the Tax Court and all the litigation that taxpayers pay for when in dispute with these institutions are also excluded. [Taxpayers pay for both defense and prosecution.]

Moody focuses on just the paperwork requirements that taxpayers must meet. Based on the IRS’s estimates of the number of hours required to fill out each form, he calculated that taxpayers spend 4.3 billion man-hours a year just in reading instructions and filling out forms. That is the equivalent of a work force of over 2,083,000 people – more than work in the auto manufacturing, computer manufacturing, aircraft manufacturing, and steel industries combined.

The US economy is highly affected by the state of tax law.

Small businesses are overwhelmed with tax-related forms and paperwork: W-4’s to determine withholding for each employee; I-9’s to track citizenship status; W-2’s to report earnings for employees; 1099’s to report payments to subcontractors, independent reps and others; W-9’s to obtain tax ID’s from suppliers and other payees. And that’s before they ever start figuring their tax liabilities.

Employees, even those with no deductions, are at a loss when it comes to figuring out what they need to keep in the way of records and how to figure what tax credits they may be eligible for.

Each of us is paying more and more each year of our “after tax” earnings to comply with the increasingly complicated income tax system.

Even taxpayers with fairly simple returns are afraid to tackle the chore themselves, so they pay someone to do it for them. Tax preparers, some of whom are poorly trained, are in great demand this time of year.

The new kid on the block is the electronic filing firm that offers “instant refunds” to people in a hurry to get back some of the money that has been withheld from their pay throughout the year. These are actually pre-refund loans, usually at high interest rates paid by discounting the amount the taxpayer would receive if s/he waited for the refund from the IRS.

Here is a recent example of the dangers and complexity of the income tax system. Last week I sat down with a young salesman who works on commission as an independent rep for a national advertising company. He didn’t even know that he is a “company” himself and needs to file a Schedule C as a sole proprietorship.

He’d been on the road so much during the past year that his motel, meals, and mileage at the standard rate of 34.5-cents per mile, wiped out a good chunk of his 1099 income, but he didn’t have many other business deductions other than his cell phone. The self-employment tax is computed at 15.3% of his net Schedule C income before exemptions and personal deductions. This is not income tax, it is the total for Social Security and Medicare taxes normally paid by the employer and employee combined. This tax had to be paid in addition to his income tax at 28%.

Needless to say, he hadn’t planned on having to pay such a large bill to Uncle Sam and had spent his commission checks as they arrived. He’d been smart enough to spend his money on such things as paying off his car and making extra principal payments on his house, but now he’s going to have to hustle to come up with enough cash to pay his taxes. He would have been better off putting money into a self-directed IRA rather than paying down his mortgage, but it was too late by the time he came to me.

Luckily, this was his first year being self-employed, so he will not be subject to penalties for not filing quarterly estimated taxes. Others will not be so fortunate.

The biggest problem for most self-employed people is lack of proper documentation and receipts for all expenses. A well-annotated daily planner can help track most business expenses, but if you are audited, nothing beats receipts.

The rules keep changing and even tax professionals have a hard time staying current. The income tax system needs to be scrapped and government pared down to the point that no other tax is needed to replace it.

Cory Layne
Editor

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DISCLAIMERS:

The information contained herein is general in nature and is solely the opinion of the author of the editorial. The reader should seek professional guidance prior to taking any action based upon this information. DeTaxUS, Inc. shall have no obligation to inform the reader of any changes in tax laws or other which may affect the information provided.