The complexity of the federal Tax Code can engender errors and underpaid taxes, according to a new government study.

The study, by the Government Accountability Office, noted that the GAO has documented millions of taxpayer errors in following complex rules for determining taxpayers’ “basis”—generally the taxpayer's investment in a property—in securities they sold or corporations they own.

The study was presented during a hearing Tuesday by the Senate Finance Committee on tax reform. The GAO study noted that the complex rules in the federal tax system may be necessary, for example, to ensure proper measurement of income, target benefits to specific taxpayers, and address areas of noncompliance.

However, these complex rules also impose a wide range of recordkeeping, planning, computational, and filing requirements upon businesses and individuals. Complying with these requirements costs taxpayers time and money, the GAO noted.

In 2005 the GAO reviewed existing studies and reported that even using the lowest available compliance cost estimates for the personal and corporate income tax, combined compliance costs would total $107 billion (roughly 1 percent of gross domestic product) per year; other studies estimate costs 1.5 times as large.

Economic efficiency costs, which are reductions in economic well-being caused by changes in behavior due to taxes, are estimated to be even larger. Although many taxpayers have simple forms of income, others do not—especially those who receive income from capital gains, rents, self-employment, and other sources—and they may be required to do complicated calculations and keep detailed records.

Tax expenditures add to Tax Code complexity in part because they require taxpayers to learn about, determine their eligibility for, and choose between tax expenditures that have similar purposes. Tax expenditures also complicate tax planning, as taxpayers must predict their own future circumstances as well as future tax rules to make the best choice among provisions.

Taxpayer errors contribute to the tax gap. For example, in 2001 taxpayers underreported $6.3 billion in net income due to misreported Individual Retirement Arrangement distributions. But taxpayers also may underclaim benefits to which they are entitled. According to GAO's past analysis, of tax filers who appeared to be eligible for a higher-education tax credit or tuition deduction in tax year 2005, about 19 percent, representing about 412,000 returns, failed to claim any of them. No single approach is likely to fully and cost-effectively address the tax gap, but several strategies could improve taxpayer compliance.

These strategies could require actions by Congress or the IRS, the GAO noted. For example, Congress can simplify the tax code by eliminating some tax expenditures and by making definitions more consistent across the tax code. IRS and Congress could take steps to enhance information reporting by third parties or expand compliance checking before refunds are issued.

“The Tax Code has grown far too complex, and it’s becoming much too difficult for honest Americans to calculate and pay their tax bill,” said Senate Finance Committee Chairman Max Baucus, D-Mont. “We should make determining a taxpayer’s responsibility as easy as possible so we are able to collect more of the $345 billion in taxes that are owed but unpaid each year.  Especially in these tough economic times, $345 billion is far too much to waste. A simpler Tax Code will ease the burden of compliance on honest Americans and help them meet their responsibilities.”

At the hearing, Baucus discussed the problems caused by the Tax Code’s increasing complexity and how that contributes to the tax gap.  According to the IRS, he noted, taxpayers and businesses spend more than six billion hours each year complying with their tax responsibilities.  And the Taxpayer Advocate added that if those six billion hours were dedicated to a given industry, it would be one of the largest in the U.S., and it would employ more than three million full-time employees.

Baucus asked whether the complexity of the Tax Code discourages compliance and to what extent it contributes to the tax gap by making it hard for taxpayers to calculate their bill accurately.  He also discussed the importance of equipping the Internal Revenue Service with the right technology to help it identify errors on returns and minimize audits.  Baucus asked what kinds of changes would need to be made to the tax code to reach a goal of a 90 percent voluntary compliance rate by 2017, and he reiterated his commitment to easing the demands of compliance on taxpayers.

The Finance Committee began its examination of the code last September with a review of the lessons of the 1986 Tax Reform Act and considered historical trends in income and revenue last December.  More recently, the Committee held hearings to discuss options to simplify tax administration and ease filing burdens for individuals and businesses, to look at changes to the tax environment over the last two decades, to consider whether the tax code could do more to incentivize economic growth and job creation and to examine ways to increase how much people respond to specific tax incentives for individuals and businesses.

“Year after year, the Tax Code becomes more complex,” said Sen. Orrin Hatch, R-Utah, the ranking Republican member of the committee. “This has contributed to two separate, but related, problems. First, the complexity of the code undercuts compliance. Complying with the Tax Code should not be a Choose Your Own Adventure story, where the complexity of the code leaves citizens guessing their tax liability.  As Chief Justice John Marshall explained, the power to tax is the power to destroy. The power to tax is massive and intrusive. And given our constitutional commitment to personal liberty and the right to property, citizens should be well aware of what their tax liability is.”

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