June 13, 2017

Tax Reform's "Simplicity Dividend"

  • Revenue-neutral tax reform can provide a “simplicity dividend” to boost the economy by reducing compliance costs and tax avoidance behaviors.
  • The tax code contains many provisions that interfere with the free market, such as the credit for purchasing hybrid cars that encourages people to buy them.
  • Tax reform that broadens the tax base – by removing these kinds of provisions – and reduces rates overall would free the economy to work more efficiently and boost growth.

Taxes will always have at least some drag on economic activity, and so the goal of tax reform should be to design a tax system that funds the government but involves the least amount of drag. If Congress gets this right, then even revenue-neutral tax reform can provide a significant economic boost.

Tax Code Hours and Cost

America’s current tax code creates high compliance costs for the economy. Businesses and individual people spend 6 billion hours annually – more than 18 hours for every man, woman, and child in America – complying with Washington’s complicated tax code, according to the IRS national taxpayer advocate. This is the equivalent of three million people working full time, at a cost of $195 billion. That’s more than 10 percent of annual income tax revenue.

Tax compliance will always cost something, but reform can greatly reduce how much. If Congress could simplify the tax code to cut compliance costs in half, we could effectively free up time and money worth nearly $100 billion every year. This extra time and money in taxpayers’ pockets would help grow the economy, even if tax revenues stay the same.

Our Tax Code Distorts Economic Behavior

Our tax code takes so much time to comply with because Congress has used it to try to influence people’s behavior and not simply as a means to collect revenue. The tax code shifts people’s consumption from what it otherwise would be in two important ways.

First, the tax code encourages taxpayers to shift their consumption to things that allow them to take a tax deduction. For example, there is a tax break for buying a new home or a hybrid car. Some people who would have bought a home or hybrid car without the tax break get the break anyway. Other people who would not have bought these items are incentivized to buy something the government favors instead of what they would otherwise buy. As a result, economic resources are directed based on government planning rather than where they can be used most effectively.

Second, businesses are incentivized to provide fringe benefits that their employees don’t value at the full cost. This form of compensation is deductible for the business but is not taxed as wages for the employee. For example, Google boasts that it provides many employee benefits, including free cooking classes. Google can deduct the full cost of the classes – maybe $100 per class. An employee might take the classes if Google is paying for them, but wouldn’t take them if he had to pay his own money. Maybe he would take the class, but only if it cost $30 or less. Google may get a tax deduction of $100 for a benefit that employees value at much less than that, all because of the tax code creates incentives to use resources less efficiently than if the policy were not in place.

The economy works best when people can make decisions about what to buy without the government’s central planners trying to steer purchases toward items it favors.

Our Tax Code Discourages Investment

Washington’s over-complicated tax code harms the economy in other ways as well. First, corporate profits can be taxed twice, through the corporate income tax and the tax on dividends. This discourages corporate investment more than if these earnings were taxed just once.

Second, forcing businesses to depreciate an asset over many years discourages investment compared to a tax code that allows immediate expensing of the full cost of asset purchases. Making changes in both of these areas would help economic growth, even if the changes are offset with revenue raisers that are less economically harmful.

A third tax code provision that hurts investment is the tax exemption for state and local bond interest income. This exemption causes high-income investors to put more money into these bonds than the market would if the tax break wasn’t there. This lowers the amount of money invested in private-sector bonds. Since private companies invest more efficiently than governments do, eliminating this break could increase economic growth.

Removing Distortions Improves the Economy

There are ways to reform the tax code so the same amount of revenue is collected more efficiently. If Congress allows the economy to work without trying to steer taxpayer behavior, we can have tax reform, not add to the deficit, and improve the economy all at once.

Issue Tag: Taxes