Five ideas to simplify the personal tax code
The federal tax code is remarkably complex. Each year, American households and businesses spend over 8.9 billion hours complying with federal tax filing rules, costing the US economy more than $400 billion. In addition, the federal tax code has generally become more complicated from year to year. In 1975, federal tax laws and rules were approximately 3.9 million words in length; today, the tax code and associated regulations are over 10 million words long.
As lawmakers consider a tax reform bill in the coming months, one of their top priorities will be to make the federal tax code less complicated. But where to start ? In recent years, legislators have introduced a number of proposals to simplify the federal tax code, and specifically personal income tax. Here are five of those proposals, in no particular order:
1. Increase the standard deduction
When households file their personal income tax returns, they are allowed to claim a standard deduction of $6,350 for single filers and $12,700 for married joint filers. However, households can choose to waive the standard deduction and instead deduct a wide range of household expenses such as mortgage interest payments and gambling losses, called itemized deductions. Most households choose to take the standard deduction, but about 30% choose to itemize.
The process of deciding to itemize deductions is relatively complex. Households should track and record their relevant expenses throughout the year, consult IRS rules to determine what expenses can be deducted, and determine if their potential itemized deductions exceed the standard deduction amount.
One way to save many households the trouble of calculating their itemized deductions is to simply increase the standard deduction dramatically. The higher the standard deduction, the more safely households can assume that they will be better off taking the standard deduction, reducing the amount of detail and simplifying their tax filing process. A number of recent tax plans have proposed large increases in the standard deduction, including the plan released last summer by House Republicans and the proposal released in April by the White House.
2. Eliminate Itemized Deductions
Another approach to reducing the complexity of itemized deductions is to simply eliminate some of them from the tax code. There are more than a dozen the itemized deductions taxpayers can claim, each with their own rules and regulations. Although many of these deductions are associated with particular policy goals (such as providing tax assistance to state governments or promoting home ownership), they are often poor means of achieving these goals.
The more deductions lawmakers eliminate, the simpler the tax filing process would be for American households. Not only would taxpayers have fewer tax provisions to comply with, but reducing the number of itemized deductions would increase the chances that households would choose to take the standard deduction, the simpler option.
A common strategy when developing a tax reform plan is to eliminate itemized deductions while lowering personal income tax rates. Eliminating itemized deductions would increase federal revenue, while lowering tax rates would decrease it; doing both at the same time would leave federal revenues unchanged, but result in a simpler tax code. As an example of this approach, the tax plan released by House Republicans last summer would eliminate all itemized deductions in addition to mortgage interest and charitable contribution deductions, and use the income to lower the tax rate. highest individual tax at 33%.
3. Reform family tax provisions
The personal income tax contains several provisions that reduce taxes for households with children and dependents. These include Child Tax Credit, Personal Exemption, Earned Income Tax Credit, Child and Dependent Credit, and Head of Household Status. Navigating through each of these different provisions makes the tax filing process more complicated for families with children.
For example, many of these provisions use inconsistent definitions of “child”. the child tax credit can only be requested by households with children under 17, while personal exemption applies to children under 19 (or students under 24). These different definitions are likely to confuse taxpayers and may lead to reporting errors. In addition, many of these provisions are complex for households to calculate and are subject to a number of detailed eligibility rules.
Several proposals have been made to align and consolidate the various family provisions in the tax code. For example, the House Republican tax plan would eliminate the personal exemption for children and use the revenue generated to increase the child tax credit. The Tax Policy Center also has a good paper outlining how the child-related portions of the Earned Income Tax Credit could be combined with the Child Tax Credit to create a simpler and more understandable family credit system.
4. Consolidate tax code savings programs
One of the most confusing parts of the tax code for many households is the wide range of tax-advantaged savings programs that are available. In any given year, a household can make contributions to a Traditional IRA, Roth IRA, SEP IRA, SIMPLE IRA, 401(k) plan, 403(b) plan, 457 plan, 529 Qualified Tuition Program, Coverdell Education Savings Account, Health Savings Account, or ABLE Account.
Each of these savings programs is subject to a different set of rules regarding eligible participants, contribution limits, available investments, permitted withdrawals, required distributions, penalties, rollovers, and a variety of other details. There are entire professions dedicated to helping households navigate their options for contributing to a tax-advantaged savings program, as well as ensuring that such plans comply with federal regulations.
These programs perform an important function: they mitigate the double taxation of personal savings, by eliminating one of two layers – taxes on savings contributions or taxes on the return on savings. However, they also create a headache for households deciding where to save their money. To the extent that legislators can combine these programs or adopt a common set of rules for them, they could make the tax system much less confusing for households looking to save.
5. Eliminate the alternative minimum tax
A particularly complicated feature of the personal income tax code is the existence of the alternative minimum tax. The AMT essentially operates as a parallel tax system to the normal individual tax code, with a separate set of rules and tax rates. Consequently, many taxpayers are required to calculate their tax payable twice: once under the ordinary tax system and once under the AMT.
Originally created in the 1960s to combat tax avoidance by very high-income earners, the AMT now applies to about 4 million households, most of which earn less than $1 million. And AMT’s compliance burden extends beyond that: in 2014, approximately 10 million households were required to file Form 6251 to determine their AMT liability, although only about 4 million were ultimately subject to the tax.
Several recent tax plans have called for the outright elimination of AMT, including the House Republican tax plan and the White House plan released in April. Eliminating the AMT would make the tax system less complex for millions of households, by avoiding having to calculate their tax payable according to two sets of rules.
The cost of simplicity
Of course, all of the ideas listed above come with tradeoffs. For example, eliminating itemized deductions would end some popular US household programs, while repealing the AMT would reduce federal revenue. Lawmakers should be aware of these trade-offs as they work to craft a tax reform bill that simplifies personal income tax in the United States.
After all, when the federal tax code is complex, there’s often a reason for it, good or bad. Sometimes the tax code contains complex rules in order to prevent evasion facilitated by creative tax planning. Other times, the tax code is complex due to legislators’ desire to target benefits to specific constituencies. Any good tax reform bill will take these considerations into account as it aims to create a tax code that is more understandable and easier to comply with.