Critical Time for Tax Code

It has taken Congress 84 years to write it, arguably the longest and most incomprehensible document in the English language. By the most conservative estimate, it costs $75 billion a year to operate. And it has spawned an industry that employs perhaps half a million Americans, making it twice as big as the steel industry.

It is the U.S. Tax Code, among the most potent forces driving American society. The public has always grumbled about taxes, but political debate about the code today is the most intense in modern history, and Congress is weighing wholesale changes.

Although the code stokes the federal Treasury with nearly $1.5 trillion a year, it has evolved well beyond a mere revenue source into a highly complex political machine for tinkering with society. Congress uses the code to accelerate economic growth, redistribute income and even give taxpayers a financial incentive to bear children. The system purports to help the poor, rich and middle class, as well as farmers, retirees, bow-and-arrow makers and college students.

Whether it actually accomplishes those goals, or has become a drag on the economy, is a subject of intense debate. But without dispute, the Tax Code is now a monument of onerous complexity.

No single attorney or accountant has a chance of comprehending the entire code, which runs about 3,000 pages. Adding up all the IRS regulations, rulings and tax court decisions yields a magnum opus of 42,000 pages--stretching higher than Mt. Everest. By comparison, when the income tax was enacted in 1913 the code ran 16 pages.

The code is so dense that taxpayers and the IRS sometimes resort to guesswork and a system of rough justice in computing taxes. About 40% of major corporate audits end up in administrative or legal disputes, some of which drag on for a decade.

The cost of complying with some provisions exceeds what the government collects in taxes--an absurdity that appears to benefit tax attorneys and accountants.

“The code is outrageously complex, no question about it,” said Sen. William V. Roth (R-Del.), chairman of the Senate Finance Committee. “The amount of resources and brainpower that goes into complying with these complex tax laws is a waste of talent. Some of our brightest minds and most able people are devoting a lifetime to understanding these detailed provisions in a very limited part of the law.”

A GOP Push for Alternate Systems

Although Congress can only point to itself for creating the code, a number of Republican leaders want to dump the old system and replace it with one based on a flat-rate income tax, a national sales tax or a value-added tax on business transactions. Dozens of Republicans have issued statements calling for the elimination of the existing tax system.

“We are reaching a critical mass in terms of pressure to do something serious,” said Kenneth Kies, the staff chief of the Joint Tax Committee, the panel of attorneys and economists that actually writes tax laws. “It is not something we can manufacture in Washington, but something that is heartfelt across the country,”

Many experts doubt that Congress can really create a simple tax system or that special interests would allow any tax system to remain simple for very long. Moreover, sweeping solutions are risky, since the entire U.S. economy has taken on a custom fit to the existing tax system.

“We have developed a very complicated economy, wrapped around a particular tax system, and I don’t think there is anybody on this planet who can say what will happen if we shift from that tax system to another,” said Greg Jenner, a former Capitol Hill tax writer who now works for the accounting firm Coopers & Lybrand. “It might be OK, but it might be unmitigated disaster.”

Given the risks, the restructuring debate will occur not over months, but most likely over the next decade. So, nothing significant about taxes is likely to change any time before the next president exits office, leaving in place a system of enormous and growing complexity.

A $75-Billion Maintenance Tab

The tax system--both individual and corporate--costs the government and taxpayers about $75 billion annually in compliance and enforcement costs, according to Joel Slemrod, a University of Michigan economist who is the leading authority on the cost of tax compliance. Other estimates range up to eight times higher.

“A cost of $75 billion is worth taking very seriously,” Slemrod, author of “Taxing Ourselves,” said. “It represents the value of resources that, if it were not for the complexity of our tax system, could be used to produce goods and services.”

Although Republicans and Democrats have decried Tax Code complexity, they enacted the single greatest increase in complexity in decades just this year under the Tax Relief Act of 1997.

Hoping to give something to every constituency, Congress made 821 changes to the code. It created four new types of individual retirement accounts, education credits, a twisted set of tax breaks for capital gains and the ballyhooed kiddie credit for dependents. One measure of the increased complexity is the length of the capital gains tax form and work sheet: this year’s have 32 lines, while next year’s have 54 lines.

“The 1997 tax bill visits complexity on the middle class as it never has before,” said former IRS commissioner Fred Goldberg. “They are going to get pummeled by the complexity. There are rules that virtually nobody can understand.”

The constant tax law changes keeps the IRS in perpetual motion. Each time the Tax Code is modified, the IRS must write specific regulations to implement the changes, a process that can drag on for years. The agency currently has 325 such regulation projects.

It isn’t any easier for IRS employees in the field, who say they are getting less training and less time to prepare for audits even as the code gets more complicated every year. To cope, Jennifer Long, a veteran IRS revenue agent who audits corporations in Houston, has loaded the trunk of her car with IRS audit manuals, code sections, regulations and other documents.

“I get to an audit 30 minutes early and go through this stuff before I go in,” she admits.

(Ironically, the IRS does not issue a single document or book called the Tax Code. Rather, the code is the sum of all tax laws, which are compiled only by outside publishers. CCH Inc., the largest publisher of tax documents, even sells its 3,000-page version of the Tax Code to the IRS.)

In part, the Tax Code has been forced to grow more complex merely to keep up with American society. Households are less likely to be nuclear families, pension plans are more varied and international trade is increasingly sophisticated.

Indeed, political subterfuge is a one of the fundamental forces that shape Tax Code complexity. Lawmakers and their staffs of tax attorneys labor to disguise tax increases and hide special-interest tax cuts.

Of course, there is also a huge constituency for complexity among some attorneys, accountants and investment firms that thrive on laws incomprehensible to average Americans.

“All the D.C. tax law firms and the accounting firms are major constituents of complexity,” said Larry Stone, a tax attorney at the Los Angeles firm Irell & Manella. “They love it because they live off it. It is a symbiotic relationship with the IRS. They say: ‘Yeah, this isn’t too complicated. I understand that regulation.’ So then, they go around the country and explain it.”

Accountants and lawyers deny they like complexity, calling it a liability risk and a source of extra work. “We like to think we are the loudest voice on tax simplification,” said Jerry Padwe, vice president of the tax section of the American Institute of Certified Public Accountants.

A Study in Verbosity

Most Americans never get a chance to see the raw Tax Code or IRS regulations, which can make ordinary tax forms seem ridiculously simple. Take, for example, this one-sentence order that the IRS issued in September in a little-noted publication known as the Handbook of Delegation Orders. It advises:

“To issue favorable determination letters and, where the facts so indicate, notices of proposed adverse determination in accordance with the currently applicable revenue procedure that sets forth the procedures of the various offices of the Internal Revenue Service for issuing determination letters on the qualified status of pension, profit sharing, stock bonus, annuity and employee stock ownership plans under section 401, 403(a), 409 and 4975(e)(7) of the Internal Revenue Service Code of 1986, and the status for exemption of any related trusts or custodial accounts under section 501(a), provided that the determination does not involve application of section 502 (feeder organizations) or section 511 (unrelated business income).”

IRS spokesman Don Roberts, offering an interpretation, says the order essentially gives four IRS district directors around the country the authority to decide whether pension and other employee plans qualify as tax exemptions.

The sentence is hardly an exception. Every year, the IRS issues thousands of pages of such verbiage in various bulletins, rulings, annotations, orders, regulations, letters of transmittal and other documents.

How many people read this is hard to say. Some experts believe that both IRS agents in the field and private tax practitioners ignore the gibberish and just try to figure out taxes based on common sense.

“The law is what people actually do,” said Stone. “There are a lot of laws out there that don’t get enforced. There are a lot of IRS rules that get enforced with a wink and a nod, because that’s as close as you can get.”

Rep. Bill Archer (R-Texas), chairman of the House Ways and Means Committee, agrees, saying that Congress is at risk of losing control over the tax system.

“Any time you have an income tax, you have subjectivity,” said Archer, who wants to kill the income tax and replace it with a national sales tax.

‘The Tax Code Is Riddled With Garbage’

The Tax Code says something about almost everything, which is not surprising for a system that reaches so far into everyday life--even such matters as the holiday season.

Want to know, for example, what a Christmas tree is? The code advises that the definition “includes evergreen trees which are more than 6 years old at the time severed from the roots and are sold for ornamental purposes.”

“The Tax Code is riddled with garbage like this,” says James D. Clark, chief tax counsel on the House Ways and Means Committee.

If you have a sex problem, but not a smoking addiction, maybe the code can help. Medical treatment for sexual dysfunction is an allowable medical deduction, but the cost of a program to stop smoking is not.

Who is the head of the household? Although it sounds like a question from a door-to-door salesman in the 1950s, the Tax Code still demands an answer. It takes the IRS 42 questions to answer definitively whether a person is or is not head of a household, complains Archer.

Most people know what they make, but defining income can be tortuous under the code. For example, military combat-zone pay is not income, but rewards for acts of civilian heroism are. The value of hams and turkeys given by employers during Christmas is not income, but unemployment benefits to the jobless are. The value of a parsonage for a priest or rabbi is not income, but cash for winning a beauty contest is.

The Tax Code’s full fury, however, is reserved for corporations, which many people assume can afford high-priced attorneys. But the bulk of corporations are small businesses operated by Americans with relatively modest incomes.

Nearly half of the 4.3 million active corporations paying taxes have net income of less than $25,000 and about three-fourths of the corporations have assets of less than $250,000, according to IRS statistics.

When the code gets too tough or complicated, people will ignore it, said Stone. One of the most difficult sections of the Tax Code and one that is often ignored involves the so-called uniform capitalization rules.

Under the capitalization rules, companies must allocate certain fixed costs and interest expenses to specific parts of their inventory and deduct those charges only when they sell the products. It was part of the 1986 Tax Relief Act, which was supposed to simplify the code.

The paperwork of allocating fixed and interest costs to specific parts of an inventory and deducting them only when the products are sold has been onerous, critics say. All the interest eventually is written off, so it affects only the timing of when companies take deductions.

“It is a shortsighted policy,” said Slemrod, the University of Michigan tax economist. “It brought revenue forward, so what you have is a one-time gain for the government, but the compliance costs last forever.”

Besides the capitalization rules, such key provisions as the alternative minimum tax and the estate tax also cost more to administer and comply with than the revenue they generate, critics say.

“You definitely get into the realm where the total compliance costs and the government costs can be more than the tax collected,” Archer said. “No question about it.” Financial products also give the IRS fits, because Wall Street is constantly creating new financial instruments to confound the code.

“Investment firms have created new products that make the law difficult to apply,” acknowledged Lon B. Smith, IRS assistant chief counsel and head of the agency’s financial products section. “Often the law is overly simplistic in its approach.”

A Constant Challenge to Outpace Tax Dodges

Smith’s office, which did not exist 10 years ago, was formed to respond to the growing perception that the investment industry was outpacing the code in devising new ways to avoid taxes.

“Financial products create a continuing challenge to the IRS because Wall Street regularly creates new financial instruments that push the Tax Code to its limit,” Smith added. “Congress draws the lines and then everyone tries to figure out how to address or avoid them.”

No sooner had Congress stopped one tax avoidance scheme last year, for example, than Wall Street found another system to do the same thing.

Fragrance magnate Estee Lauder and her family avoided an estimated $125 million in 1995 with a hedge known as a “short against the box.” In simple terms, the technique allows a taxpayer to lock in a profit on a stock by taking a short position, in which an investor borrows a like amount of stock through a broker and sells it. The maneuver effectively allowed the Lauder family to lock in a profit on its stock appreciation, but avoid capital gains taxes by not actually selling the original stock.

Congress outlawed the tactic, making a short against the box a taxable event. But Wall Street is now increasingly using opposing buy-and-sell options--called a collar--to do essentially the same thing.

Outwitting big corporations is never as simple as it seems, especially the way politicians discuss the issue with the public.

During the 1992 presidential campaign, Bill Clinton railed at the astronomical salaries paid to private executives and said he intended to halt “excessive executive pay.”

He told an audience at the University of Connecticut, “I don’t think the rest of taxpayers should pick up the bill when we provide unlimited deductibility for executive salaries in companies, no matter how exorbitant, even when the companies are losing money.”

Not long after the election, Congress passed and Clinton signed changes to the Tax Code that prohibited corporate tax deductions of executive salaries of more than $1 million--unless the pay is based on a performance plan set up by outside board members and the pay plan is approved by shareholders.

It looked like just the kind of populism that Clinton and other politicians had espoused, clamping a lid for the first time on corporate tax write-offs for executive compensation.

But experts say the IRS lacks the expertise to judge whether corporate performance goals are legitimate or are so lax that an executive is guaranteed to meet them. IRS officials said they are not aware of a single deduction on executive performance-based compensation that has been disallowed.

Moreover, the $1-million limit on deductible salaries had the unintended effect of being viewed in corporate America as the government’s approved minimum level for a top executive’s pay.

“It is a terrible law,” said Kevin J. Murphy, a professor of finance at USC who has conducted detailed studies of the law. “It has encouraged salaries to go higher. You had the government saying $1 million was the right salary. It has encouraged a lot of salaries to go up to $1 million that were below that level.”

The law also has a loophole that allows corporations to pay out nonperformance-based compensation above the $1-million limit after an executive retires, an action that has kept salaries growing and allowed corporations to keep their write-offs, said Marilyn Johnson, an accounting professor at the University of Michigan who has studied the issue.

Goldberg, the former IRS commissioner, goes further, charging the that law not only has driven salaries higher and imposed administrative costs on corporations, but actually reduced tax collections.

Since corporate executives are taxed on their salaries at a higher rate than corporations are taxed on their profits, the federal government ends up poorer every time a corporation defers executive compensation and successfully takes a deduction.

Goldberg said “tax experts are paid an enormous amount of money to work the system. It is a terrible indictment of the system. It makes me gag.”

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Observations on the Tax Code

“We [judges of the U.S. Tax Court] have from time to time complained about the complexity of our revenue laws. . . . Our complaints have obviously fallen on deaf ears.”

--Judge Arnold Raum

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“Trying to understand the various exempt organization provisions of the Internal Revenue Code is as difficult as capturing a drop of mercury under your thumb.”

--Stephen Swift, managing director of BEA-Credit Suisse Associates of N.Y.

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“The current income tax code is the chief source of political corruption in the nation’s capital.”

--House Majority Leader Dick Armey (R-Texas)

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“When Congress talks about simplification, taxpayers may well be reminded of Emerson’s comments regarding an acquaintance: ‘The louder he talked of his honor, the faster we counted our spoons.’ ”

--Michael Graetz, tax attorney

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“I bet if you actually read the entire vastness of the U.S. Tax Code, you’d find at least one sex scene.”

--Dave Barry, newspaper columnist

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“We cannot lose sight of the fact that complexity is the result of our struggle for fairness.”

--Margaret Milner Richardson, former IRS commissioner

Quotations compiled by CCH Inc.

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TAX CHANGES UNDER CONSIDERATION BY CONGRESS

Growing public dissatisfaction with the federal tax system has brought widespread calls for a “simple and fair” system. Here are some of the proposals:

NATIONAL SALES TAX: A uniform tax of 15% to 30% on the value of all goods and services sold at retail. Under proposals offered by conservatives, the tax would apply to personal consumption, housing, automobiles and financial services, among much else. Proponents claim such a tax at a 27% rate could replace the income and payroll taxes and provide a $2,788 rebate for families.

Pluses: A sales tax would be simple in concept, relieving taxpayers of the annual filing of tax returns. Proponents say it would unburden U.S. industry as well, allowing consumer prices to drop and offset part of the tax. The tax would theoretically also encourage personal savings, since no taxes would be collected on interest income.

Minuses: Critics say a national sales tax would severely burden lower-income Americans, who spend a higher proportion of their income on goods subject to sales taxes. It would create huge tax bills on big purchases: Buying a $200,000 home could create a $60,000 tax liability. A national sales tax combined with state sales taxes could impose rates approaching 40%.

VALUE ADDED TAX: A tax on value created in products and services, collected from every firm along the production and distribution chain. In its most popular form, known as the credit invoice VAT, each firm pays a tax on its sales but deducts the VAT already paid on the goods and services it purchases. Ultimately, the VAT is added to the retail price of goods and services at a rate from 15% to 30%.

Pluses: A VAT is supposed to be self-enforcing. Since firms can claim a credit for the VAT paid by their suppliers, they have an incentive to make sure those suppliers have complied with the tax. Like the retail sales tax, a VAT would relieve individuals of filing tax returns and could encourage greater personal savings.

Minuses: A VAT is messier in practice than it is in principle, judging by the experience of European countries that have tried it. The tax often becomes a supplement rather than a replacement for income taxes, and it is also subject to tax evasion by industry. Nobody is sure who ends up paying the VAT, since it affects wages, profits and product prices.

FLAT TAX: A tax that individuals pay on their wages and corporations on their cash flow, based on a single 20% tax rate. Under one proposal, the tax would provide a $22,000 standard deduction for a joint return. Developed by professors Robert Hall and Alvin Rabushka of Stanford University, the flat tax is theoretically similar to a VAT but is collected differently.

Pluses: With its relatively high standard deduction, the tax would be progressive, supporters say. With a single tax rate applying to individuals and corporations, the taxation of interest and dividends is streamlined and a huge volume of 1099 tax information forms would be eliminated.

Minuses: Critics charge that the flat tax is little more than a tax on payrolls, exempting the wealthy from any tax burden on their interest, dividend and capital gains. Individuals would still have to file tax returns and deal with the Internal Revenue Service.

SIMPLIFIED INCOME TAX: A reform of the existing tax system that would eliminate some of the most complex provisions that have largely failed to enhance fairness or bring in significant revenue. The tax would eliminate the alternative minimum tax, the earned income tax credit and many deductions--including charitable contributions, state taxes and perhaps the mortgage interest deduction. It would allow lower overall tax rates.

Pluses: A simplified tax system would reduce the burden on taxpayers to comply with often complex IRS rules. Lower tax rates are also seen as crucial in reducing tax fraud and noncompliance, which currently costs the federal government more than $100 billion per year.

Minuses: The elimination of many popular deductions would create political outcries by special interests, including the increasingly powerful tax-exempt sector of the economy. A simpler income tax would also leave intact the IRS and the requirement to file tax returns. Successful efforts to simplify the system are often reversed, as was the case after 1986 reforms.