(Archived Content)
FROM THE OFFICE OF PUBLIC AFFAIRS
LS-548Chairman Campbell, Senator Dorgan, and Members of the Committee:
I appreciate the opportunity to participate in this hearing on return-free tax systems. I want to thank the Chairman for calling this very important hearing and Senator Dorgan for the leadership he has shown in this area.
The goal of tax policy is to raise revenue in an equitable, efficient, and simple manner. Often, these goals - equity, efficiency, simplicity, and fiscal responsibility - may be in conflict. A tax system that is perceived as equitable may be complicated, while a system that is simple may be unfair or inefficient.
The individual income tax, which finances a large share of the Federal government's operations, is the fairest and most progressive broad-based tax. By basing tax liability on income and certain personal characteristics, it provides a mechanism to adjust for differences in ability to pay. However, this flexibility comes at a cost, as many perceive the current system to be complex and income tax compliance to be burdensome. Thus, this hearing, which examines ways to reduce taxpayer compliance burdens without undermining the basic fairness of the income tax, is extremely important.
What is the best way to make income tax compliance less burdensome? One option that has been adopted by over 30 countries is a return-free filing system. In most of these countries, taxpayers meet their tax obligations entirely through tax withholding payments made throughout the year. Other countries rely on tax agency reconciliation, in which tax authorities prepare tax returns for individuals based on information returns from employers and others, and send taxpayers a completed tax form for their review. In the United States, this Administration proposed to reduce taxpayer burdens by simplifying the tax law and encouraging electronic filing, telefiling, and the use of tax preparation software. As described by the Commissioner, the IRS has underway a number of innovations designed to make its contact with taxpayers less burdensome.
A number of issues must be considered in evaluating options to implement a return-free filing system.
- What changes in tax law and procedures would be required to facilitate a return-free filing system? How would these changes affect other objectives of the tax system, such as equity?
- Would a return-free system shift compliance burdens from individual taxpayers to employers and financial institutions?
- Would such a system result in a loss of privacy, because individuals might, for example, have to report to their employers information about their family circumstances and other sources of income to enable exact withholding?
- To what extent would taxpayers have to file some sort of report during the year, containing some of the same information currently included in tax returns, to establish the proper withholding schedule or their eligibility for credits, such as the earned income tax credit (EITC)?
- What would be the role of the IRS, and what additional resources would be required to implement and operate a return-free system?
- What would be involved in coordinating state income tax systems with the new return-free apparatus?
- Are there other ways to achieve the benefits of a return-free tax system at less cost and without sacrificing other goals?
In my testimony today, I will address the sources of taxpayer burden in the current system, alternative models of return-free systems and the experience of other countries in implementing such systems, and the potential effects of such systems in the United States. Finally, I will briefly discuss the Administration's legislative proposals that would reduce taxpayer compliance burdens.
Current Law Filing Requirements
Every income tax system imposes certain obligations, beyond the actual payment of taxes, on taxpayers, government agencies, and third parties. Individuals must provide the tax agency and possibly their employers with some basic information about their income and family status. Employers and other third parties withhold taxes on income, and must report both the amount of income paid and taxes withheld to the taxpayer and the tax agency. The tax agency must compute the individual's taxes to determine if the correct amount has been paid. Income tax systems around the world obtain the required information and collect taxes in different ways.
As the Commissioner has described, in the United States, taxpayers interact with the IRS in three stages: pre-filing, filing, and post-filing. The pre-filing stage often begins the day taxpayers start work, when they compute the number of withholding allowances they are entitled to claim. Taxpayers may also pay estimated taxes in quarterly installments throughout the year. They may also need to keep records documenting expenses and other items that affect their tax liability.
Throughout the year, businesses, non-profit organizations, and Federal and state government agencies also incur tax compliance costs. Employers must withhold Federal income taxes on wages and transmit these amounts to the Treasury. Under certain circumstances, income taxes may also be withheld during the year on unemployment benefits, distributions from pensions and individual retirement accounts, interest, dividends, and large gambling winnings. During the first three months of each year, businesses and other payers send over a billion information reports (Forms W-2, 1099, and others) to taxpayers, the IRS, and the Social Security Administration (SSA), showing the amount and type of income received and taxes withheld, if any, during the preceding year.
This filing season, about 127 million taxpayers will complete the second stage of tax compliance by completing and filing a tax return. Through tax returns, taxpayers notify the IRS of their actual income, filing status, and dependents, and they reconcile the amounts of taxes paid during the year with the amounts they owe the Federal government. Over 85 percent of these filers are legally required to file a tax return. In most cases, they are required to file because they incurred a positive individual income tax liability, but 7 million filers are required to file even though they do not owe income taxes in order to claim a dependent or to pay self-employment income taxes or other special taxes. About 15 percent (over 18 million filers) file a return even though they are not required to do so in order to obtain a refund of overwithheld income taxes, the EITC, or for other reasons.
The third stage of tax compliance - post-filing contacts - may begin shortly after the IRS receives a return. During processing, the IRS may detect mathematical or clerical errors and send notices to taxpayers advising them of adjustments that have been made to their tax returns. Later in the year, when SSA and IRS have finished processing and editing information reports, the IRS will match Forms W-2 and 1099 to tax returns, contacting taxpayers if discrepancies are found. After further review, the IRS may identify other returns as being questionable, and as a consequence, an audit may be initiated, resulting in the issuance of a notice of deficiency to the taxpayer. Altogether, about 9 million notices will be sent this year. Less than 7 percent of tax filers will actually have contact with the IRS during the post-filing stage.
In differing degrees, each of these three stages imposes burdens on individuals, employers, other third parties, and the Federal government. The cost of administering all Federal taxes is reflected in the $8.6 billion budget of the IRS, but we cannot easily disentangle the costs to the Federal government of operating just the individual income tax. Costs to individuals, employers, and other third parties are even more difficult to measure.
Recently, significant technological advances have likely lowered taxpayer compliance burdens. Personal computers and tax software have become more widespread, powerful, and cheap. Tax software enables taxpayers to input data, and let the computer do complicated computations. It also simplifies information reporting by businesses. Technology has also helped tax professionals do research through the creation of on-line services and CD-ROMs. The IRS has built on these technological advances to reduce taxpayer compliance burdens. During the 1999 filing season nearly one out of every four taxpayers (over 29 million) filed electronically, including about 6 million taxpayers who telefile their return over the phone. Some states now allow taxpayers to file their federal and state taxes in one electronic transmission. An IRS web site enables taxpayers to download forms and publications to their own computers. This site registered over 750,000 "hits" during fiscal year 1999.
The costs of administering the current tax system should be weighed against the benefits of the current system. In FY 2000, the Federal government will raise nearly half of total Federal receipts -- $951.5 billion -- from the individual income tax system. The tax is fair, contributing significantly to the overall progressivity of the U.S. tax system, without placing undue tax burdens on typical families. In fact, the Federal income tax burden for a median income family of four is lower today than it has been since 1965. Nearly 70 percent of filers have a statutory marginal tax rate of 15 percent or lower. In addition, the income tax provides taxpayers with important incentives for savings and investment, for charitable contributions, and for work effort by low-income individuals.
Types of Return-free Systems
In contrast to the U.S. system with its end-of-year reconciliation on tax returns, over 30 countries exempt some of their taxpayers from the requirement to file a tax return. During the past decade, two states - Michigan and Louisiana - have enacted "no-form" pilot programs. There are two types of return-free tax systems, exact withholding and tax agency reconciliation, with many possible variations on each type.
Exact withholding: In an exact withholding system, the tax agency attempts to insure that the exact amount of tax liability is withheld so that taxpayers are not required to file returns at the end of the year to obtain refunds or pay a balance due. Over 30 countries operate exact withholding systems. These systems require taxpayers to report some information to either employers or the tax authorities at the beginning of the tax year. The information is used to calculate withholding allowances by either the employer or the tax authority (who must then report the applicable withholding rates back to the employer in a timely fashion). Taxpayers may be required to report this information on a regular basis or whenever there is a change in their circumstances that affects income tax liability.
: In an exact withholding system, the tax agency attempts to insure that the exact amount of tax liability is withheld so that taxpayers are not required to file returns at the end of the year to obtain refunds or pay a balance due. Over 30 countries operate exact withholding systems. These systems require taxpayers to report some information to either employers or the tax authorities at the beginning of the tax year. The information is used to calculate withholding allowances by either the employer or the tax authority (who must then report the applicable withholding rates back to the employer in a timely fashion). Taxpayers may be required to report this information on a regular basis or whenever there is a change in their circumstances that affects income tax liability.Several types of exact withholding systems exist. Cumulative systems (used in the United Kingdom) aim to withhold exactly the right amount of taxes at each point in the year. Final withholding systems (used in Germany and Japan) make adjustments to the final paycheck in the tax year to achieve exact withholding. Exact withholding systems typically apply a PAYE ("pay as you earn") tax withholding plan for wage income.
Tax systems that rely on exact withholding often have structural features that facilitate taxation at source. For example, the individual - not the married couple - is generally the unit of taxation. Interest and dividend income is often made exempt or taxed at the source at a flat rate. Relative to the U.S. income tax system, PAYE systems are also characterized by fewer rates, fewer deductions, and fewer tax credits. This means that employers and other payers can withhold the appropriate amount of tax from taxpayers without obtaining significant amounts of personal and financial information from taxpayers (such as spousal income, medical expenses, or child care costs).
The British system illustrates the important relationship between tax structure and tax administration. As in many PAYE systems, the unit of taxation in the United Kingdom is the individual. The system has fewer rates, with about 80 percent of taxpayers taxed at the basic rate of 22 percent. Taxes on interest and dividends are withheld at the source at the basic rate. Capital gains on owner-occupied housing are completely exempt from taxes, as compared to the United States, where gains under $500,000 ($250,000 if unmarried) are exempt. Other capital gains are taxed on an inflation-adjusted basis and only realized gains in excess of 7,200 pounds (about $11,400) per person are subject to taxation. There are also fewer itemized deductions, and the manner in which taxpayers may claim these deductions differs from the U.S. system. For example, mortgage interest relief is provided at the source at a 15 percent rate. There are fewer tax preferences, and they are not typically targeted by income. Similarly, deductions are not subject to income-based caps.
In net, about two-thirds of British taxpayers were able to avoid filing tax returns for tax year 1999-2000. Those who have to file are largely high-income taxpayers with asset income (which are subject to tax withholding at the basic marginal rate), those with capital gains above the exempted amount, and those with self-employment income. Further, while low-income working families do not have to file a tax return in order to claim the EITC-like "Working Family Tax Credit," they must submit a separate return-like application at the end of each six-month period to Inland Revenue.
Tax agency reconciliation: Taxpayers may be relieved of the burden of filing even in systems that do not have exact withholding. In tax agency reconciliation systems, taxpayers can elect to have the tax agency prepare their return, with tax filing occurring in four steps. First, electing taxpayers provide basic information to the tax authority. The tax authority then calculates tax liabilities, given the information returns it receives from employers, financial institutions, and other payers, and the information obtained from the taxpayer. The taxpayer then has a chance to review (and contest) these calculations. Finally, refunds or tax payments are made.
: Taxpayers may be relieved of the burden of filing even in systems that do not have exact withholding. In tax agency reconciliation systems, taxpayers can elect to have the tax agency prepare their return, with tax filing occurring in four steps. First, electing taxpayers provide basic information to the tax authority. The tax authority then calculates tax liabilities, given the information returns it receives from employers, financial institutions, and other payers, and the information obtained from the taxpayer. The taxpayer then has a chance to review (and contest) these calculations. Finally, refunds or tax payments are made.Because withholding does not have to be exact, tax agency reconciliation systems may not place as great a burden on employers and other payers as exact withholding systems. Moreover, it may be easier in a tax agency reconciliation system to apply progressive rates to a combination of income derived from different sources and to allow taxpayers to claim certain types of deductions or credits. But tax agency reconciliation systems are not costless to employers, other third party payers, or the tax authorities. In order to ensure timely payment of refunds and balances due, payers must report payments to the tax authorities as close to the end of the tax year as possible, while the tax authorities must quickly absorb, process, and match a large number of information returns. Taxpayers must review these calculations and institute procedures, if necessary, to contest erroneous calculations.
Only two relatively small countries, Denmark and Sweden, operate tax agency reconciliation systems. About 85 percent of Denmark's taxpayers and 74 percent of Sweden's taxpayers had their returns filled out by the tax authorities in 1994.
Neither an exact withholding nor tax agency reconciliation system provides an easy way to handle capital gains, business income, alimony or other payments between individuals, employee business expenses, moving expenses, contributions to individual retirement accounts, most itemized deductions, or most tax credits. If the United States were to adopt either system, many taxpayers would likely still be required to file a return, even with significant structural changes to the current tax code. Both types of systems also raise new administrative concerns. We turn next to a discussion of these issues.
Administrative Issues in Shifting to a Return-Free Tax System
The Internal Revenue Service Restructuring Act of 1998 requires the Secretary of the Treasury to develop procedures for the implementation of a return-free system for "appropriate" individuals by 2007. Until then, the Secretary is required to report annually on the additional resources the IRS would need to implement a return-free tax system, the changes to the Internal Revenue Code that would enhance such a system, the procedures developed for the implementation of a return-free tax system for appropriate individuals, and the number and classes of taxpayers that would be permitted to use these procedures.
Today, I would like to preview some of the administrative issues that we will examine in this year's report as we begin to identify individuals for whom a return-free tax system would be appropriate under the current individual income tax.
The first issue concerns the withholding formulas applicable to wage income. In 2001, approximately 21 million taxpayers (out of 128 million taxpayers) will have income solely from wages, will claim no credits other than the child tax credit, will not itemize deductions, and will be in either the 0- or 15-percent tax brackets. For these taxpayers, tax liabilities equal 15 percent of wage income above the appropriate standard deduction and exemption amounts minus the $500 child tax credit. Because almost all wage income is subject to withholding already, these taxpayers could be shifted into a return-free system more easily than the rest of the filing population. An additional 1.5 million taxpayers have all of the above qualifications but face a marginal tax rate higher than 15 percent.
Even though most wages are subject to withholding, the current system would have to be modified in several ways in order to eliminate a filing requirement (or to minimize refunds or balances due) for most of these 21 million taxpayers. Additional information and computations would be required on the Form W-4 to accurately adjust withholding for the child tax credit. Further, the current withholding formulas are not designed to be exact for dependent filers, dual-career couples, or taxpayers who do not work all year or have more than one job during the year. If only non-dependent filers with income solely from one job were exempted from a return-filing requirement, only about 8.5 million taxpayers would qualify.
The withholding formulas could be modified to meet the needs of most taxpayers, but the additional precision would make the computation of withholding allowances on Form W-4 more complex. Under an exact withholding system, workers might have to file Forms W-4 more frequently during the year, whenever their family or financial status changed in a way to affect tax liability (for example, if they marry, divorce, or have a baby). They might also have to share more personal and financial information with their employers in order to determine the correct withholding allowances, raising privacy and security concerns.
Although the United States has never had a return-free tax system, we have had experience trying to fine-tune withholding formulas. When the IRS introduced a new, more precise Form W-4 in 1987, as required by the Tax Reform Act of 1986, it was quickly withdrawn in response to criticism from taxpayers, employers, and the Congress who found the new form complicated and burdensome.
Expanding the scope of mandatory withholding raises a second set of issues. If withholding at the source were extended to interest, dividends, pensions, individual retirement account distributions, and unemployment insurance benefits, the number of taxpayers eligible for a return-free tax system would increase to 43.5 million. Mandatory withholding would expand the scope of a return-free system and could improve compliance, but would create new administrative costs for financial institutions and other payers.
Past attempts to extend withholding requirements to non-wage income have met with significant resistance from banks, financial institutions, and other businesses. The increased usage and substantially lower costs of computer processing of business financial records may have made withholding more feasible than when last attempted nearly 20 years ago. To further reduce administrative costs, relatively small payments and some payers (such as individuals who hold seller-financed mortgages) could be exempted from the withholding requirements, but that would either require more recipients to file or the exemption of such income from tax.
An additional 13.5 million taxpayers could be exempted from a return-filing requirement if eligibility for the EITC could be determined through other means. Administering the EITC in the absence of a return-filing requirement raises a third set of issues. Eligibility and credit computations are very sensitive to changes in family status and income during the year, making it difficult to accurately predict a taxpayer's EITC in advance. The British have responded by establishing a separate claims application process for the Working Family Tax Credit (WFTC). Thus, they have not been able to totally eliminate some sort of filing requirement for WFTC claimants.
In sum, depending on the extent of changes to current tax administration, a final tax return requirement could be eliminated for between 8 and 57 million taxpayers, or up to 44 percent of the tax filing population, without making any structural changes to the tax code. While these taxpayers would be spared the costs of preparing a final return, the net reduction in burden may not be great. Most of these 57 million taxpayers currently file the relatively simple 1040A or 1040EZ. Even under a return-free system, these taxpayers would still be required to provide some of the information from these forms (for example, filing status and dependents' identification) to the IRS on a regular basis. In fact, the return-free process may be more complex than filing for some taxpayers.
Additional concerns include the extent to which some administrative costs would merely be shifted from the taxpayers to their employers, other payers, and the IRS. Adoption of an exact withholding system means shifting some costs to taxpayers and employers, by expanding the scope and precision of withholding. This is likely to meet with some resistance. In a tax agency reconciliation system, one billion information reports would have to be filed earlier and processed and perfected much sooner by the IRS in order to complete returns by April 15, and refunds might be paid out slower than under the current system. These requirements would add to the burden on employers, other third parties, and the IRS, and yet taxpayers may be reluctant to participate in the new system because of possible delays in their refunds, even with the acceleration of delivery and processing of information reports. States whose tax systems piggyback on the Federal tax return would also incur additional costs or delays under either system. A key issue in either system is who would bear responsibility for mistakes on the tax form prepared by the tax authority or mistakes in exact withholding made by either the tax authority or the employer/payer.
I raise these issues not as obstacles but as design issues that must be addressed before we could adopt a return-free system. Many of these issues were first considered in a report entitled, "Current Feasibility of a Return-Free Tax System, prepared by the IRS in 1987. In that report, the IRS found that there were serious timing and accuracy problems in implementing a return-free system, but that technological improvements in IRS's tax processing could make a return-free system more feasible in the future.
As I discussed earlier in my testimony, there have been significant technological improvements that have eased compliance burdens, even with a return-filing requirement. It is possible that these new technologies will also enable us to make the transition to a return-free filing system with minimal burden to certain categories of taxpayers. It is also possible that these technological advances will allow us to find other ways to reduce compliance burden while maintaining an end-of-year filing requirement.
Administration Proposals to Reduce Compliance Burdens
In the meantime, there are a number of steps that can be taken to reduce taxpayer compliance burdens without sacrifice of other policy goals. In his testimony, Commissioner Rossotti has described administrative steps taken by the IRS to lessen these burdens.
The FY 2001 budget contains a number of proposals that will reduce taxpayer compliance burdens by simplifying the tax laws. Most notable among these is a proposal that would build upon the temporary AMT reforms enacted on a bipartisan basis last year. This proposal would permanently modify AMT calculations by removing the dependent personal exemption as a preference item. By 2010 when it is fully phased in, this change would reduce the number of taxpayers affected by the AMT by over one-half. In addition, the FY 2001 budget would reduce the number of itemizers by 4 million and the number of dependent filers by 400,000 by increasing standard deduction amounts. Other proposals would reduce recordkeeping for taxpayers by simplifying the child dependency tests and indexing the maximum exclusion for capital gains on the sale of personal residences.
Some progress has already been made. President Clinton proposed and signed into law 40 tax simplification measures as part of the Taxpayer Relief Act of 1997. As a result of that simplification, 99 percent of homeowners will not have to pay capital gains tax when they sell their home; 9 out of 10 corporations no longer have to worry about complex AMT calculations; and many dependent children are able to earn more income without being subject to tax.
Technological advancements provide other means to reduce taxpayer compliance burdens, rather than through eliminating a filing requirement. Electronic filing eases tax computations and reduces both taxpayer errors and the need for subsequent contacts between the taxpayer and the IRS. It also permits taxpayers to receive their refunds faster and provides taxpayers with immediate proof of filing. Recognizing these benefits, the 1998 Act sets a goal for the IRS of having 80 percent of tax year 2006 returns filed electronically.
To help achieve that goal, the Administration has proposed in the FY 2001 budget a new temporary, refundable tax credit for electronic filing of individual income tax returns. The credit would be $10 for each electronically filed return and $5 for each TeleFile return filed for tax years 2001 through 2006.
This concludes my remarks. We look forward to working with the Congress in making the tax system work better for all Americans, for example, by enacting simplification provisions contained in the FY 2001 budget. Thank you once again for providing me with the opportunity to testify. I would be pleased to answer questions.