Scott Sumner  

It's that time of year again

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I just paid someone $3500 to do my income taxes. And even with that expenditure, I had to spend a lot of time and aggravation on the project.

I just paid someone zero dollars to do my payroll taxes. And I spent zero hours on the project.

Is it any wonder that I prefer payroll taxes to income taxes? That $3500 and my foregone time is pure, 100% deadweight loss.

A new NBER study suggests that I'm not alone, they used a clever statistical technique to estimate the compliance costs of taxes:

Many Americans complain about how much of their earnings each year go to taxes. But in How Taxing Is Tax Filing? Using Revealed Preferences to Estimate Compliance Costs (NBER Working Paper No. 23903), Youssef Benzarti shows that many taxpayers forgo tax savings in order to save the time, effort, and other costs required to itemize deductions on their returns. . . . Aggregate compliance costs appear to have risen over time, from $150 billion in 1984 to $200 billion in 2006 (both figures in 2016 USD). This suggests that compliance costs are about 1.2 percent of GDP in recent years.
The following graph illustrates the intuition behind the study:

Screen Shot 2018-04-01 at 4.47.52 PM.png
PS. Some on the left would suggest that I should stop complaining, as I was in the "top 1%" during 2017. That's wrong. It's true that the reported taxable income on my tax form put me in the top 1%, but that reported income was about three times my actual income. And that's because the government forced me to include the (nominal) capital gain on the sale of my house, even though that gain represented housing inflation and even though I immediately turned around and bought another house of roughly equal value. From a "consumption" perspective, nothing changed.

In economics we assume that it's consumption that determines utility, not income. But the IRS doesn't agree; they insist I report that capital gain as "income". Academics like Thomas Piketty then use that same highly misleading "income distribution" data to try to understand "inequality" in America.

BTW, one of silliest talking points I hear is: "Why would voter X oppose high capital gains taxes on the rich, given that his income is merely middle class?" Yes, it's middle class, until you earn that big capital gain. Remember, 73% of Americans spend at least part of their life in the top 20%.


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COMMENTS (15 to date)
Todd Ramsey writes:

I will try to remember that payroll tax is costless the next time I am trying to follow the Social Security, Medicare, and Additional Medicare tax rules and regulations and going through the steps to get them paid on time for the ~25 people who work for me.

Although YOU may not see any of the costs of payroll taxes, they exist nonetheless. And probably passed on to the employee in some small way.

However, your point is taken. Payroll taxes are a fraction of the complexity of income taxes.

Matthias Görgens writes:

Greetings from Singapore, were taxes are simple and low, and public infrastructure is still plentiful and a joy to use.

Justin D writes:

--"And that's because the government forced me to include the (nominal) capital gain on the sale of my house, even though that gain represented housing inflation and even though I immediately turned around and bought another house of roughly equal value. From a "consumption" perspective, nothing changed."--

But in fairness, from a consumption perspective, you've also gone for years enjoying untaxed owner-equivalent rent.

--"Is it any wonder that I prefer payroll taxes to income taxes? That $3500 and my foregone time is pure, 100% deadweight loss."--

I hate the compliance cost of taxes too, but how do you deal with the political problem of people thinking that the wealthy are getting off scot free because they'll pay a tiny portion of their taxes as payroll tax?

You could have an income tax with a universal savings deduction, but then I think we're still probably stuck with all of the compliance burden, especially since a true consumption tax would probably require taxing owner's equivalent rent.

Ideally you could have a VAT with a very broad base and one flat (and somewhat high) rate, though I'm sure that would likewise be politically difficult and compliance might be compromised by the high rate. Maybe a couple of ancillary taxes like a carbon tax and excise taxes could keep the rate down a bit.

Maybe there is no perfect tax system.


Justin D writes:

@Todd, part of the problem is that the payroll tax system is more complex than it needs to be. A single flat federal payroll tax would be a lot easier to administer than multiple payroll taxes with different rate brackets.

If you had $10,000 of payroll in a given period and the rate was a flat 18%, you'd just send in $1,800. You wouldn't have to bother with "well, Wally is currently no longer paying any Social Security, but my CFO Alice earns enough to pay the extra Medicare tax." And additionally, you wouldn't worry about a separate Federal income withholding tax either.

Ed Hanson writes:

You scare me about your house. I thought the first (double for joint) $250,000 of gain was an off the form event. But I assume the purchase of a similar house still works to delay capital gains.

Now that taxes are over enjoy your time, wish I was there.

As one who has foregone itemizing in the past, good-bye for now.

Ed

BillD writes:

For $3500 you almost certainly have a very complex return, e.g. self employment, trusts, partnerships.

Even among those complexities much of what happens is just putting known numbers in the correct boxes.

Yet even that is hard. My kids have trusts that have basic investment (div, int, cg) income reported on 1099s. Yet even with those few numbers filling out the 1041 forms is a multi-hour pain.

The amount of manual entry in the 21st century boggles the mind. The ability for Intuit and H&R Block to block IRS automation is frustrating.

Alan Goldhammer writes:

Scott- TR Reid's recent book on reforming the tax code is an excellent read and you can sail through it in a couple of hours, "A Fine Mess
A Global Quest for a Simpler, Fairer, and More Efficient Tax System" He points out that in The Netherlands, it takes about 10 minutes to check the figures the government has on your income and that's about it; they do the tax calculation for you.

We have sometimes had complicated tax filings because of real estate holdings and transactions but I have always found that Turbo Tax works just fine and at $70 is much cheaper than what you pay. Of course you still have to collect all the deductions and so forth but once the data is entered it's carried over into the next tax year.

The worst thing is inherited trusts as you not only have to file a Federal return and possibly multiple state returns. I'll never forgive my mother for setting up trusts for our two kids; it wa a royal PITA to administer.

mbka writes:

Another greeting from Singapore.

This year my income tax filings were more complex than usual: two separate employers with several income streams: payroll, director's fees, dividends. One employer auto-filed my income with the government, the other (my own company) did not.

As a result, this time it took me about 10 minutes to prepare for the online tax filing because I had to open some help pages to verify that my dividends were really non-taxable. Then it took me the usual 10 minutes to actually file the whole thing. Payment will be by giro, no extra minutes to process. To be honest it may have been less than 10 minutes but let's not brag here.

I admit that as an employer, I probably spent a cumulative 60-90 minutes earlier in 2017 to set up my social security account (me as an employee) online, both with the government and with the bank for the giro. After that it's all automated though, so zero extra minutes for the payroll processing.

All this to say, it can be done.

BC writes:

That reminds me, when do our tax returns start fitting on a postcard?

ChrisA writes:

Flat rate income tax (don't bother with payroll tax its the same thing). VAT. Automatic withholding taxes on all dividends and interest payments. 2% wealth tax on all assets above 500k in lieu of capital gains/death duties. NGDP targeting so less recessions so less need for discretionary tax hikes. There - tax system solved.

Scott Sumner writes:

Justin, Real estate is easy to handle, indeed we already have the solution---property taxes. Our actual property taxes are regressive, but they could (and should) be progressive.

Alan, I tried Turbotax for a couple of years, but eventually my return got too complicated.

I've basically been donating lots of money to the IRS for years, before I hired someone to do my taxes.

Antischiff writes:

Dr. Sumner,

Very good post and I agree. And yet every "tax reform" bill merely scratches the surface, at best. Unfortunately, lots of entrenched interests crush true reform efforts.

Mike W writes:

From a "consumption" perspective, nothing changed.

Then why sell the old house?

Steven Hankin writes:

Can the NBER study ascertain all the administrative costs. Whatever might be considered by the NBER by the NBER) as administrated costs, the cost should also include any costs borne by individuals (and thus businesses) with regard to considering the impact of the federal tax on any decision made.

Business as well as individuals constantly factor into their decisions income tax implications. So, I would include with these administrative costs all the mental planning time that people do factoring in the tax implications. For example, when I sell an asset that will generate a large capital gain (or a large capital loss), I need to consider what my current tax rate will be for that year as well as what my tax rate will likely be in the future (or for a capital loss, what capital gains I will realize in that year to offset that loss). For a business, the planning implications are often complicated and many. Yet we can get a handle on those costs since the business pays accountants and lawyers not only to file returns and keep records but to plan as well and the business deducts those costs against its taxable income. Yet, for an individual he can't deduct his/her time and effort spend on such personal planning. So could these costs ever be estimated.
If we wants a low cost, tax system, we should consider a Henry George type "land tax."

Steven Hankin writes:

Can the NBER study ascertain all the administrative costs. Whatever might be considered by the NBER by the NBER) as administrated costs, the cost should also include any costs borne by individuals (and thus businesses) with regard to considering the impact of the federal tax on any decision made.

Business as well as individuals constantly factor into their decisions income tax implications. So, I would include with these administrative costs all the mental planning time that people do factoring in the tax implications. For example, when I sell an asset that will generate a large capital gain (or a large capital loss), I need to consider what my current tax rate will be for that year as well as what my tax rate will likely be in the future (or for a capital loss, what capital gains I will realize in that year to offset that loss). For a business, the planning implications are often complicated and many. Yet we can get a handle on those costs since the business pays accountants and lawyers not only to file returns and keep records but to plan as well and the business deducts those costs against its taxable income. Yet, for an individual he can't deduct his/her time and effort spend on such personal planning. So could these costs ever be estimated.
If we wants a low cost, tax system, we should consider a Henry George type "land tax."

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