Tax Simplification in the United States

By Michael E. Mares.

Tax legislation of increasing magnitude and complexity is being passed by the U.S. Congress virtually every year. The Internal Revenue Code (IRC or the Code) now contains many extraordinarily complex provisions. The Treasury regulations interpreting those provisions likewise have become increasingly complex. The frequency and scope of legislation make it very difficult for the Treasury Department to issue timely and adequate guidance. As time passes, taxpayers, their advisers, and the Internal Revenue Service (IRS) face increasing uncertainty as to the correct tax treatment of an item.

Complexity interferes with business decisions by making the after-tax economics of transactions less certain. Furthermore, some observers express concern that the compliance burden borne by taxpayers and the IRS diverts resources from more productive endeavors.

A tax system that is simple for all taxpayers may never be designed, but a simpler tax system is a critical and achievable goal. The problem of an overly complex tax system has arisen in part because of the dominance of other legislative goals, such as revenue enhancement, rate reduction, and economic and social policy. Consideration of the simplification aspects of a proposal must occur at all stages of the legislative process. Changes must be made in the process to provide adequate time for a thorough consideration of tax proposals, including simplification options.

Simplification yields a number of benefits. Economic resources will become available for more productive endeavors. Taxpayers will be more willing and able to comply when they can understand their tax responsibilities. Further, taxpayers’ confusion, frustration, and the psychological burden of dealing with their responsibilities will be reduced.

Complexity

The structure of the tax law creates complexity beyond that associated with specific Code provisions. The different treatment accorded capital gains and losses and ordinary income and losses is one example of structural complexity. Interactions between various Code sections and the use of cross-referencing also create substantial complexity. For example, the owner of “listed property” must first understand the rules for cost recovery in IRC section 168 and then recognize the impact of the IRC section 280F provisions on cost recovery calculations.

The introduction and codification of new concepts add to structural complexity. For example, the alternative minimum tax (AMT) introduced many new concepts and produces a great deal of interaction with existing regular tax provisions. The AMT significantly increases the number of taxpayer choices and makes the selection of appropriate planning and compliance strategies much more difficult. In other instances, new meanings are assigned to familiar, long-used terms. For example, the word passive retains its historical general meaning of unearned but now is also used in a much more technical sense in IRC section 469. Lack of statutory definitions of phrases, such as, trade or business and earnings and profits, and the accompanying reliance on regulations and case law, permit flexibility but also increase complexity. Multiple sets of rules in the Code (e.g., those governing attribution of ownership) suggest that horizontal drafting should be employed as frequently as possible.

Effect on Taxpayers Not Targeted by a Particular Provision

Provisions targeted primarily at taxpayers with complex tax situations, who are often better able to afford extensive tax advice and return preparation, often create substantial and unintended problems for less sophisticated taxpayers. There may be situations in which a burden has to be placed on many taxpayers in order to provide reasonable treatment for the targeted taxpayers. The use of thresholds and safe harbors can alleviate this problem, but sometimes it can create others.

Since ignorance of the law has never been considered an acceptable reason not to comply, knowledge is required of all taxpayers, whether or not they are affected by a particular provision. Thus, while a safe harbor may in the end exempt a taxpayer, it is the taxpayer who incurs the additional compliance burden of determining whether or not a particular provision applies and whether a safe harbor can be invoked.

Furthermore, a sense of unfairness results from the “cliff effect” of a threshold or safe harbor, by which a taxpayer just misses qualifying. Phasing the rules in and out increases the perception of fairness but adds complexity to the calculations required.

A taxpayer may learn the law, keep the necessary records, and perform the required calculations, only to find that the threshold exceeds the amounts he or she has calculated, as in the case of miscellaneous itemized or medical deductions. Another taxpayer may fail to keep records and forgo deductions because of the perceived compliance burden.

On the other hand, many less sophisticated taxpayers must keep track of depreciation and basis for AMT purposes, even though they may never actually find themselves subject to the alternative minimum tax. In instances such as this, income thresholds would help reduce the record keeping burden.