Home inFocus Government and Government Overreach (Fall 2013) The Federal Tax Code – Irreparably Broken?

The Federal Tax Code – Irreparably Broken?

Eileen J. O'Connor Fall 2013

Casting aside the checks and balances our Founding Fathers so brilliantly embedded in the U.S. Constitution, the current Administration has time and again kept its promise to go its own way without regard to the will of the people as expressed by Congress or the rule of law as interpreted by the courts.

The boldness of this Administration’s open dismissal of the Constitutional role of Congress to write the laws, and of the Courts to interpret them, has spawned a plethora of elite scholarship as well as accessible blog postings on what is viewed as overreach by this Administration.

Perhaps you wondered what in the Constitution authorized the Executive Branch to hand out hard earned and under-penalty-of-law collected taxpayer dollars to get “clunkers” off the roads. Or by what authority the White House strong-armed BP behind closed doors to commit, before any legal process had begun, billions of dollars to cover the costs of remediating the Deepwater Horizon disaster. Or where the bankruptcy laws were when the Administration stiffed Chrysler’s preferred creditors in favor of its lower ranking—in terms of bankruptcy priorities—campaign-contributing unions.

But while the actions of the federal government in recent years—and we need not pretend they are limited to this Administration or to the Executive Branch—have gone so baldly and boldly beyond what most Americans have considered the proper bounds of government, government overreach is nothing new in the tax arena. But for the most part it is not the Executive Branch that is to blame.

Income Tax Laws in a Nutshell

The income tax provisions of the Internal Revenue Code can be summed up—depending on how much detail you want—in just a few sentences. Everything is taxable and nothing is deductible unless otherwise specified. Everything that is taxable is taxable now, and everything that is deductible is deductible later unless otherwise specified. It’s all those provisions to “otherwise specify” that create the complexity for which tax code is so famous. And reviled.

Let’s take a quick look at it. The Internal Revenue Code imposes several different types of taxes. It imposes the income tax, a tax on estates and gifts, excise taxes, and, new last year with the opinion of Chief Justice Roberts in NFIB v Sebelius, a tax on failing to buy an insurance policy to cover health situations you may never face.

To simplify the discussion, take just the income tax for now. It seems pretty straightforward that an income tax would tax income, and that the person to pay it would be the person who received it. And that the amount of income subject to the tax would be determined after taking into account the expenses associated with producing the income. Income minus the cost of producing the income equals taxable income. Multiply the taxable income by the applicable tax rate, and you have your tax liability. Clear enough.

Why then, do we have a tax code with more than 15,000 provisions relating to the income tax? Add the other taxes, and you have a code of nearly 30,000 provisions.

Watch Congress for a while, and it’s not at all difficult to see how the tax code got this way. By the time they headed off for their August recess, lawmakers had, in the six months since the beginning of this Congress, introduced in the neighborhood of 400 bills to amend the Internal Revenue Code. Not 400 changes to the Internal Revenue Code, but 400 bills containing who-knows-how-many thousands of changes.

People who were involved in the last major reform of the Internal Revenue Code in 1986 lament that, since then, the Code has undergone more than 15,000 changes. Our founding fathers understood the threat of such mutable laws. Under the pseudonym Publius, James Madison wrote on February 27, 1788:

It will be of little avail to the people, that the laws are made by men of their own choice, if the laws be so voluminous that they cannot be read, or so incoherent that they cannot be understood; if they be repealed or revised before they are promulgated, or undergo such incessant changes that no man, who knows what the law is today, can guess what it will be tomorrow.

— Federalist Paper No. 62

Who can doubt what Madison’s reaction would be to today’s Internal Revenue Code?

The deadline

Nothing focuses the mind quite like a deadline. Time is running out for the chairmen of the Senate Finance Committee and the House Ways and Means Committee, so they are joining forces to accomplish tax reform.

Max Baucus (D-MT) is Chairman of the Senate Finance Committee, but only until the end of this session. He announced in April that he would not run for re-election next year to a 7th term in the Senate. Dave Camp (R-OH) is Chairman of the House Ways and Means Committee. His chairmanship is term-limited by the rules Republicans adopted in 1995. So even if he is re-elected next year to a 13th term in Congress, his days as Chairman of the House Ways and Means Committee will be over at the end of this session.

They are working together to build support for tax reform while they are still in a position to do something about it, putting together a “traveling road show,” and setting up a website to collect ideas from the public. On the home page of their site they write:

We’ve launched this Web site, TaxReform.gov, to give you the opportunity to provide your input, and we are active on Twitter (@simplertaxes) as well. No need to travel to Washington. Through the use of social media, we want all Americans to participate directly… Tax reform can’t be about politics. It has to be about restoring some trust in government, improving the lives of the people we serve, about boosting the economy, about creating jobs in Montana, Michigan and across America.

These are laudable goals: improving lives, boosting the economy, creating jobs. But through tax reform? True to their theme, in a statement announcing upcoming visit to San Francisco and Silicon Valley, the tax buddies said, “The focus of the California trip will be how a simpler and fairer tax code can help spur innovation and boost America’s economy.”

So true. Like taking your boot off someone’s neck can help them breathe better.

The Camp-Baucus view of the tax code is one of the problems with it. Lawmakers view tax laws as their own personal toolkit, holding the solution to all problems. Want to discourage something? Tax it or deny a deduction for it. Want to encourage behavior? Provide a deduction for the cost of doing it. Want to really encourage it? Provide a credit for the cost of it. Credits have gotten particularly out of hand; more on that in a moment.

Blank slate

In addition to his efforts with Rep. Camp, Sen. Baucus has also partnered with Sen. Hatch (R-UT), ranking Republican on the Senate Finance Committee. Together, they are pioneering a “blank slate” approach to tax reform. It does not, however, really start from scratch, as its name might suggest, designing a new tax system. It does not reconsider, for example, the double taxation of corporate income, progressive rate brackets versus single rate of tax, the distinction between ordinary income and capital gains, or whether, having paid income taxes on all your earnings all your life, your estate should owe taxes at your death on what you managed to save instead of spend, or whether the United States should continue to have the world’s highest rate of tax on the income of corporations, multi-national or otherwise. There are, however, separate efforts addressing that last issue.

Rather than asking, as do most tax reform projects, what about the current Code ought to be simplified, amended, jettisoned, or replaced, Hatch and Baucus have informed their colleagues that their working hypothesis is that all “special provisions” in the current Code have to go, except those for which there is “clear evidence that they: (1) help grow the economy, (2) make the tax code fairer, or (3) effectively promote other important policy objectives.” By “special provisions,” Baucus and Hatch mean, “exclusions, deductions and credits and other preferences that some refer to as ‘tax expenditures.'”

Tax Expenditures, Especially Credits

If you spend your money on something of which Congress approves, you are permitted to deduct that amount in determining your taxable income. That is, you “get” a deduction.

But a deduction only reduces the cost of the thing of which Congress approves. So if you are in, say, the 35 percent tax bracket, and the outlay was $10,000, you are still out of pocket $6,500 even taking into account the “tax benefit” of the outlay.

When Congress really wants to encourage or reward something, it provides a credit for it. Credits were already an interesting enough phenomenon, but then Congress got even more imaginative. In recent years, they have positively outdone themselves.

Early credits were, and still are, a percentage of the amount of the approved expenditure. The investment tax credit, for example, when there was one, was for some years 10 percent of the amount of your investment in capital equipment. The credit for household and dependent care services necessary for gainful employment is 20 to 35 percent of the cost of the services. Dozens of other credits are similarly limited to a percentage of your Congressionally approved outlay.

Then, Congress began to provide credits amounting to 100 percent of the approved expenditure. But even old-fashioned credits of 100 percent of the outlay were only useful if you had a tax liability against which to apply them. So lawmakers invented the refundable tax credit. For these, if you don’t have a tax liability against which to apply them, the government will send you a check.

This is the type of credit Congress has used to enlist employers in—shall we say— spreading the wealth around. The Earned Income Tax Credit (EITC)is designed to reduce the tax burden of people who have jobs and are receiving a paycheck. While the income tax can be reduced to zero by withholding exemptions, Social Security withholdings cannot. This is where the EITC comes in. It offsets Social Security taxes, effectively reducing or eliminating them. The mechanics of the credit are this: while the employer withholds income and payroll taxes from some employees, it pads the paychecks of the employees who qualify for the EITC. The employer literally takes from some employees and gives to others every payday on behalf of the federal government. If the credit exceeds the applicable taxes, the employee gets a check from the Treasury after filing his or her tax return.

The EITC, while hailed by some as one of the most effective anti-poverty programs, is known to be fraught with fraud. The Treasury Inspector General for Tax Administration reported earlier this year that at least 21 percent and as much as 25 percent of the Earned Income Tax Credits paid—not applied for, paid—in the past two years were fraudulent. GAO disagrees. It says the fraud rate was between 27 percent and 32 percent. One hundred eleven billion (yes, billion) and as much as $133 billion (yes, billion) in EITC was handed out to fraudsters in the ten year period ending last year. Your hard earned tax dollars at work. Supporting criminals.

In recent years, even the refundable credit wasn’t quite flexible enough for lawmakers. Voila: the refundable transferrable credit. So not only do you not have to have a tax liability against which to apply the credit, you can ask Uncle Sam to send your check to someone else. This last is useful in the case of IRS-facilitated Obamacare. Having determined, on the basis of the information you provided for that purpose, that you qualify for an Obamacare subsidy, the IRS will send that subsidy—the refundable transferrable credit—to your health insurance provider.

But if tax incentives are such an effective way of encouraging people to engage in certain economic or social activities, why then are there so many companies in the business of undertaking studies to identify tax deductions and credits for which you qualify but didn’t claim?

What Can We Do?

1) Insist that our elected representatives have, or at least appreciate, real world experience. Having signed the back of a private sector paycheck would be good. Having signed the front would be even better.

2) When listening to lawmakers talking about legislative proposals, listen for “make sure.” Once you begin listening for it, you will hear it interminably. “By enacting this provision, we will make sure that no child ever goes hungry again.” Too many lawmakers really do believe wishing—or legislating—makes it so. If only. Wake them up. A people free to act in their own best interests is the best guarantor of good outcomes.

3) Insist that virtually all credits be eliminated from the Internal Revenue Code except those that represent an actual payment of taxes. You should have a credit against your taxes for the tax payments that you have made through withholding or quarterly payments, with your extension request, the application of last year’s overpayment, or your overpayment of Social Security or railroad retirement taxes. Any other outlay that is treated as though it were a payment of federal taxes ought to be subjected to the appropriations process and administered by an agency that knows something about the subject matter.

4) Make it clear to your elected representatives in the House and Senate that you do not measure their success by the number of bills they have proposed or gotten passed, and certainly not by the amount of your money that they have given away, either directly or through tax breaks. You measure their success by the ways in which they have restored our government to its Constitutionally limited functions and thereby restored our personal and marketplace freedoms.

It was the employer deduction for employer-provided health care with no counterbalancing employee reported income for that element of compensation that created the problems in the health care industry. Interfering with the doctor-patient relationship and installing a third-party payor skewed decision-making on both sides of the doctor-patient relationship. Patients no longer considered the relative costs of various health care options, and doctors no longer looked to the patients or their communities for payment. Rather than remove this distortion from the market, though, Congress instead nationalized one-sixth of the national economy and eliminated forever, unless it can be repealed, Americans’ ability to select and pay their own doctors.

5) Where taxes are concerned, aim the blame where it belongs. Sure, the IRS has done a lot lately that deserves criticism and even condemnation. That is a subject for another time. For now, let us focus on the laws it is called upon to enforce, and acknowledge that too many people blame the IRS when they should be aiming their derision at Congress. More often than not, what the IRS is being criticized for is something Congress has required of it. Put the blame where it belongs: our lawmakers. Let’s hold them accountable for what they have caused our tax code to become, whether by adding to the problem or failing to fix it.

Eileen J. O’Connor served as Assistant Attorney General for the Tax Division, 2001-2007. She is the author of the forthcoming book “Stop It Already!”