This is the first of a four-part series on the principles of taxation. In the next year, the public will be besieged by various claims about taxes. These claims cannot be evaluated without enunciating principles that apply to all taxes of any type. Without foundational principles, we can get no further than ideology and propaganda, and shrillness rather than reason must dominate the discussion. This first post deals with the question of Simplicity in taxation. Reader comments are welcome.
In spring a young man's fancy may turn to thoughts of love, but in winter they turn to darker thoughts indeed, and none darker than the thought of filling out his income-tax returns. That season is hard upon us, and the joy of the Christmas is inevitably followed by the gloom of the tax season, as Santa Claus is replaced in our imaginations by Uncle Sam. The former giveth, the latter taketh away. And while one is awash in receipts and W-2s and 1099s and forms of every sort, it is natural to cry out, Why can't we have a simpler tax code? And even more damaging to our perception of the tax system is the knowledge that the tax-code is laden with “gifts” for special-interest groups large and powerful enough to purchase a legislator or two; the corporations expect a return on the 100's of millions they pour into politics, and special tax treatment is part of that return. So along with a desire for a simpler tax comes a cry for a fairer tax.
Such a cri de coeur creates a demand for schemes which are “simpler” and “fairer.” And with such a great demand, there comes any number of plans from both reformers and charlatans alike willing to supply the demand. And, of course, it gets harder and harder to tell the reformers from the charlatans. Indeed, there may not be much of a difference between them on this issue; every attempt to simplify the tax code has made it more complex; every attempt to make it fairer has made it more unfair.
To be sure, the tax-code is laden with bounties for special interest groups which could easily be removed and so greatly improve the tax code. But even removing these would not greatly simplify the code. The plain fact is that the complexity of any tax code arises from the complexity of the thing being taxed; no code can be simpler than the thing to which it applies. And in the case of an income tax, the tax code cannot be simpler than the concept of income. In truth, there is no single or simple definition of the concept of income either in economics or in accounting. Or rather, there are any number of contending definitions, each of which has some validity in a given situation or for a given purpose. In the accounting trade, the rules for defining income (or profit) are given by the Generally Accepted Accounting Procedures (GAAP) which is governed by the Financial Accounting Standards Board (FASB). The GAAP manuals currently run to five volumes. Thus, no tax-code that deals with income can be shorter than these five volumes.
But in reality, the code must be very much longer than the five volumes of GAAP. Why? Because GAAP allows a wide variety of methods for calculating income since it covers, in theory, every possible situation. Using GAAP, a business firm could simply select its level of income by combining the most advantageous methods. This is not really a problem when it comes to most uses of financial statements. For each type of business, the users expect a certain type of accounting, and a business that violates these expectations will likely be punished by investors, bankers, and financial analysts. But the opposite is the case with the tax code; selecting the method that most understates income will result in rewards for the firm and an intrinsic unfairness in the tax-code. Therefore the simplest possible code will not only be as long as GAAP, but must be some multiple of the five volumes, since it must state the allowable accounting methods in each situation. We can know state an absolute principle for any income tax-code: An income tax-code cannot be, even in theory, any shorter than the Generally Accepted Accounting Principles that define income and must be, in fact, some multiple of these procedures.
We can apply this principle to a specific “tax simplification” proposal, the Flat Tax. Former congressman Dick Armey has proposed this tax with a simplified business tax return that fits on a post-card. Basically, there is one line to state the firm's “income,” another to state its cost of goods sold, which is then subtracted from the income, and a 17% tax rate is then applied. That's it. Pretty simple, no? Well, no, it is very complex. Each of the lines, “income” and “cost of goods sold,” would have to be backed up by forms which are in fact every bit as complex (if not identical to) the current forms. For example, when is “income” recognized? At the time the order is booked? At the time delivery is made? At the moment payment is received? At each stage of completion for works-in-progress? For different kinds of businesses, each one of these methods has a certain validity and is used in different situations but not in others.
The complexities that apply to “cost of goods sold” are even greater. Should inventories be charged when they are purchased or when they are consumed? Should capital equipment be charged off in the first year or over the life of the asset? These, and literally thousands of other issues are covered in the GAAP manuals and must be specified in the law and detailed on the tax return. Armey may be able to summarize the forms on half a page, but the supporting forms would be just as lengthy as they are today. They cannot, even in principle, be any shorter.
At this point, the alert reader might interject, “yes, that might be true for business taxes, but certainly personal taxes can be just as short as Dick Armey says: state your income from the W-2, apply the flat rate, and that's that!” The problem with this is that the amount on the W-2 is already the result of complex calculations covering several volumes of the tax-code. Certain amounts one does not actually receive (like the FICA tax) are counted as income, while certain amounts one does receive (like health benefits) are not counted. The return that Dick Armey is proposing already exists; it is the 1040EZ. This form is “simple” only because the complex accounting has already been done by somebody else and because all other possible deductions are denied in advance. The flat tax “simplifies” only a few pages of the tax code: those pages which deal with the varying rates of taxation. Of the thousands of pages, it addresses only a few; everything else would have to remain in place.
This brings us to our second principle of taxation: Whatever the government taxes, it must also measure, regulate, and control. If the government taxes income, it must be able to define, measure, track, and audit income. There must be a bureaucracy and a both a legislative and judicial process to accomplish this task. If it taxes consumption, it must be able to define consumption, and track every transaction that fits that definition. The oft-advanced claims of “reducing bureaucracy” ring hollow because the bureaucracy must be co-extensive with the thing taxed. One can “abolish” an income-tax bureaucracy like the IRS only by replacing it with a bureaucracy as large and complex as the thing you choose to tax; if that thing is simpler, the bureaucracy can be simpler; if it is more complex, the bureaucracy will be more complex. There is simply no way around this principle. By selecting the thing taxed, one must, at the same moment, select the size and scope of government. A simpler government can be obtained only by taxing something simpler.
Next Post: Fairness.