Sunday, April 25, 2010

The Paradox of Simplifying the Tax Code

It's been a couple months since my last post as I've been busy helping people navigate the complicated mess that is our income tax code. And the last couple of years, I've noticed an interesting contrast between what people say they want, and what they actually want.

Over and over again I hear from the media and simply talking to people in public the common refrain that our tax code is way too complex. An unnecessarily complicated tax code creates an enormous burden on business and individuals, stifling productivity. Out in the open, you hear almost universal support of the idea of simplifying the tax code. So if we live in a democracy and nearly everybody says they want a simpler tax code, why don't we have one?

Simple. People don't tell the truth. Or they simply don't think things through to the very next logical step.

Everybody says publicly they hate how complicated the tax code is. But privately things are very different. Privately, most people buy tax software or pay somebody like me to search for all the tax breaks they can possibly get. And what is a tax break? It's simply an exception, a "complication," to the straight-forward application of tax rates to income. And everybody wants as many as possible when it comes time to do their taxes.

If we want to simplify the tax code, we'll have to start eliminating all these tax breaks. Who wants to vote for eliminating the deduction for mortgage interest? Who will vote for ending exemptions and credits for dependents? Any takers? Maybe a few, but overwhelmingly people tend to like tax breaks. Sure, most people aren't big fans of "unfair" tax breaks for "others." But it turns out when you try to eliminate any tax break, suddenly the "others" turn up to argue their tax breaks are just as "fair" as the tax breaks you receive.

I'm not saying our complicated tax code is a good system. But I am saying that "simplifying" the tax code is one of the most politically difficult things to accomplish in a democracy. Any politician who promises to simplify the tax code is probably blowing smoke.

And let's consider just how much most people would like the alternative. It turns out our tax code already has built in to it a couple of flat taxes. First, there's the FICA taxes that come out of people's paychecks automatically and aren't subject to deductions or credits. Because they're almost invisible, most people don't think much about them (plus only half the amount is shown on your paycheck, the other half truly is invisible to employees). However, self-employed people see this tax directly as it's not withheld automatically from them. They have to cut a check. And most self-employed people howl about this one when they learn about it. Over and over I have to explain to self-employed people that their medical expenses, their mortgage, their kids...none of those personal deductions make any difference when determining self-employment tax. And self-employed people hate it.

The other flat tax in our system already is Alternative Minimum Tax. Like Self-Employment Taxes, this tax is pretty flat as well. (There's a 2% higher tax rate at the higher end of the income spectrum, and they can still deduct mortgage interest and charity, but other than that it's pretty close to a flat tax.) And what tax is universally loathed by upper-middle-income earners who sometimes find themselves subject to it? AMT, of course. Again, people are outraged that their kids, their state income tax, and countless other deductions they get under the normal tax system don't make any difference for AMT purposes.

Turns out that--privately, at least--most Americans hate a flat tax even more than a ridiculously complicated tax.


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