February 22nd, 2007

There’s gold in them thar hills

Posted in  Tax 
Author: Lawrence A. Hunter || Location: Washington, DC, USA

Congress and the IRS bureaucrats remind me of old crusty miners obsessed with a vein of gold they know exists but have never been able to get their picks into.  “There’s gold in them-thar hills,” they rant incessantly.   The only problem is, that gold is so difficult to extract, the collateral damage to the environment produced by trying to extract it would be devastating, and the value of the gold once extracted, great as it may be, is no where near sufficient to cover the costs of extracting it.  Or take Antarctica, which is known to possess natural resources of enormous value beneath the ice cap.  The only problem is, the cost of extraction in the harsh Antarctic conditions would be staggering, meaning recovery will not be economical anytime soon, if ever.  
 
The so-called Tax Gap—the $290 billion difference between the amount taxpayers theoretically owe the federal government under the current tax code and the amount the government actually collects, about 14 percent of revenues owed—is a lot like that elusive gold.  It’s there for sure but anyone who thinks about it seriously realizes most of it simply cannot be extracted in a cost-efficient manner.  Trying to do so would impose such collateral damage to the economy and our constitutional rights that Congress shouldn’t even think about it.
 
The Internal Revenue Code already imposes unacceptable collateral damage on American taxpayers.  A conservative estimate is that GDP is at least 15 percent smaller than it could be under a more economically rational tax system.  The collateral damage to our constitutional system may be even greater, if harder to quantify.  As tax historian Charles Adams puts it:
 

“The income tax has always been associated with frauds, even in Britain when it was a very low 3 percent.  Gladstone said fraud was an unavoidable part of income taxation.  I am going to offer an explanation that has nothing to do with greed or evil-mindedness.  There is a naked confrontation between the citizen and the state in the income tax system that does not exist with indirect taxes.  The demand for taxes on income is backed by an inquisition into the taxpayer’s affairs—one’s personal life, how one runs one’s business, and how one spends one’s money.  This is the power associated with despots, and every taxpayer knows that the tax system is a pocket of totalitarianism in an otherwise free society.  This makes taxpayers mad and rebellious.  When the rates of tax become progressive to the point of confiscation, they know they are being robbed, and any assertion that anyone would consent to this kind of robbery is perfect nonsense.”

 
The Internal Revenue Code is incomprehensible and unintelligible even to the experts who prepare the tax returns, enforce the law and collect the taxes.  As former Treasury Secretary John Snow told the Congress just before leaving office, “The problem you're talking about [the Tax Gap] is the bewildering complexity of the code itself.”  IRS Commissioner Mark Everson spoke the same uncomfortable truth:  “The complexity of our current tax system is a significant reason for the tax gap, and fundamental reform and simplification of the tax law is necessary in order to achieve significant reductions.”
 
The extraction costs of the current tax system are already extraordinarily high just to extract the first 86 percent of what’s theoretically owed.  The American taxpayer is so perplexed, bothered and bewildered by the tax code they spent $265 billion (virtually the same amount as the Tax Gap itself) last year just trying to comply with the 54,000 pages of laws and accompanying regulations.  Yet, even with this vast expenditure of money, virtually no one is sure they successfully complied with the law.  In fact, The Treasury’s own Inspector General for Tax Administration found an 84-percent error rate in spot audit visits to 26 different IRS Assistance Centers across the country in 2004.  According to the Treasury IG, “IRS employees incorrectly prepared 19 of the 23 tax returns prepared” during the audits.
 
Now comes the Congressional Research Service to confirm this uncomfortable reality.  According to the CRS study:
 

“The estimates of the gross tax gap have been heavily publicized; perhaps as a result, some public officials have emphasized better enforcement of tax laws in order to raise revenue. Three factors limit the dollar amount that can be collected by increased enforcement. First, much of the gross tax gap for individual income tax filers is due to types of unreported income that are difficult to detect. Second, some of the detected tax liability cannot be easily collected, particularly from those taxpayers who are currently unable to pay. Third, many detected tax liabilities are so small relative to enforcement costs that it is not cost-effective to pursue collection.
 
“From fiscal years 2001 to 2006, greater tax enforcement efforts by the IRS increased enforcement revenue from $33.8 billion to $48.7 billion.”

 
Wow!  A whole $14.9 billion, less than one percent of revenues owed.  How much damage would the IRS wreak trying to collect the last 14 percent of revenues it thinks it’s due?
 
It’s time someone told the Congress critters about the Pareto Principle, named after the Italian economist Vilfredo Pareto, which is better known today as the 80/20 rule.  Pareto’s observation was simple:  In virtually all human endeavors, a small fraction, about 20 percent, of the total effort accounts for a large share, approximately 80 percent, of the results.  In today’s technological world, many people believe the rule is really more like 90/10.
 
Just think what the Pareto Principle implies:  one has to expend 80 to 90 percent of his total effort just to achieve the remaining 10 to 20 percent of the results.  Simply not worth it.
 
If Congress and the Bush Administration are serious about improving the efficiency of the way it collects taxes, it will give up trying to impose more burdens on American taxpayers to extract every last penny theoretically owed under the current tax code and replace that tax code altogether with something that makes more economic sense and is more consistent with our constitutional democracy, such as a flat tax or a retail sales tax or a hybrid, low-rate retail sales tax and business transfer tax.  
 
Until they do, Congress will remain like those ranting old gold miners fantasying about all that elusive gold that obsess  their dreams.