Just in time for consideration by President Bush's new bipartisan panel on tax reform, National Taxpayer Advocate Nina Olson told Congress that the complexity of the Internal Revenue Code is the most serious problem facing both taxpayers and the Internal Revenue Service.

"Without a doubt, the largest source of compliance burdens for taxpayers and the IRS alike is the overwhelming complexity of the tax code, and without a doubt, the only meaningful way to reduce these compliance burdens is to simplify the tax code enormously," Olson said.

In her annual report to Congress, Olson cited the alternative minimum tax, the Earned Income Tax Credit, and the large number of provisions designed to encourage taxpayers to save for education and for retirement as illustrations of the complexity of the 1.4 million-plus-word tax code.

She noted that, in addition to the struggles of tax practitioners and taxpayers to understand the code, its complexity places a huge burden on the IRS. From low-income taxpayers trying to understand the complexities of the EITC to middle-class taxpayers snared by the AMT, the code presents complex challenges.

For example, she noted, most taxpayers subject to the AMT don't know it before they prepare their taxes, and discover too late that they underpaid their tax and are subject to a penalty for failure to pay sufficient estimated tax.

"Taxpayers often must complete a 12-line worksheet, read eight pages of instructions, and complete a 55-line form simply to determine whether the AMT applies," she said. "To say the least, this 'surprise' factor - a direct result of the AMT's complexity - is not conducive to building public confidence in the fairness of our tax laws."

Meanwhile, observers say that the president's bipartisan panel is likely to advance an incremental approach rather than a true radical reform. "We were interested in two things - who was on the panel and what the deadline was," said Tom Giovanetti, chief executive of the Lewisville, Texas-based Institute for Policy Innovation. "Those are indications of whether the panel is likely to champion radical or incremental change."

"Given the fact that none of the panel members are associated with any particular radical proposal, and the extremely short timeline, that is the clue that they're going to advocate some kind of incremental approach, rather than a [value-added], sales or flat tax."

"We expect a slate of incremental reforms," he continued. "There's nothing wrong with that - we tend to do things in this country very gradually and incrementally, in stages over a period of a decade."

"In addition," Giovanetti said, "the president has clearly pointed in a direction that doesn't lead to massive overhaul, with his restrictions on changing the mortgage interest deduction and the fact that one of their options has to include the existing code. ... If they move from depreciation to expensing, that's a significant reform; if they eliminate the AMT, that's significant; and if they reduce the marginal corporate income tax rate, it's significant. If not a flat tax, it's flattening the tax, and that's a good move."

"In the ideal world, they would throw out the existing code and come up with a new approach, but that's not likely to happen," he said. "But our expectation is that they will come up with incremental but significant reform."

Tax preparers a symptom

Olson cited the extensive reliance on paid preparers as demonstrating the complexity of the code. "While one might expect that high-income taxpayers with extensive financial holdings would disproportionately rely on preparers," she said, "we find it particularly significant that more than 71.5 percent of low-income taxpayers who claim the Earned Income Tax Credit paid money to have their returns prepared. And among taxpayers who were affected by the AMT - which is projected to hit nearly 35 million taxpayers in 2010 - 75 percent used paid preparers."

"Something is seriously wrong with a tax system so complex that a significant majority of taxpayers lack either the ability or the time to comply with it on their own," she said.

"All of this is valid," agreed Lee Shepard, a contributing editor of Arlington, Va.-based journal Tax Notes. "But the reason the code is complex is because that's the way we want it."

"Look at the child tax credit form," Shepard said. "It's four pages long, and it basically says that on a full moon on a Tuesday you can have a credit for your child. Fairies didn't come in the middle of the night and write the form - the IRS goes to Congress with a mock-up and shows them exactly what the form will look like based on the proposed legislation."

"Congress knows how messy it is, but they're in the habit of writing messy provisions because people nitpick," she said.

She agreed that radical simplification is not on the way. "Nobody has a value-added tax in place of an income tax," she noted. "In Europe, VAT is in addition to the income tax, and it is not self-administering. It's a whole new kind of administration, and there is a tremendous amount of cheating and fraud."

"A sales tax is also no picnic to administer," she said. "On the state level, you've got sales tax auditors hanging around the back room of pizza places to figure out how much cheese it bought. You're asking the retailer to act as a collection agent."

"The flat tax is a tax on labor income. It's basically a consumption tax. We're getting toward that result already, so why throw over the apple cart just to get the rest of the way?" she asked.

"The Taxpayer Advocate is absolutely right," said William White, CPA and chief executive of Saint Joseph, Mo.-based OnLine Taxes. "The code is too complex, but what we can do about it is a challenging question. We don't anticipate anything radical coming out of the panel's recommendations, because there are too many people with a vested interest in the current code."

One possibility White foresaw is a national sales tax on top of the existing code: "It would give a significant increase in exemptions, so individuals at the bottom would be taken out of the code and the taxes they paid would be replaced by the sales tax. A big part of our economy doesn't file returns and doesn't pay tax, and that's a way to catch the 'tax gap' income."

A radical reform that truly simplifies tax is unlikely, because so many sectors of the economy feed off the code, according to Holliston, Mass.-based preparer Larry Novick. "Any reform that lowers taxes will decrease the attractiveness of municipal bonds," he said. "Then municipalities will suffer, and they'll raise their interest rates and may have to increase their property taxes. The tax prep industry would suffer, along with companies like CCH and RIA. Even insurance companies that sell annuities to save taxes would suffer."

"Reform has already happened for hundreds of thousands of taxpayers because of the higher standard deduction," he said. "So many have refinanced at lower rates that they no longer need to itemize."

Giovanetti, of the Institute for Policy Innovation, cautioned that the bipartisan panel must avoid the mistakes of the last major reform, in 1986. "In 1986, the intentions were good, but halfway through it was doomed," he said. "Although it lowered tax rates at the margin, it sharply raised the rates on new saving and investment. This paved the way for the stock market crash in 1987 and set the stage for the recession in 1991. It is fundamentally important to avoid the mistakes of 1986."

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