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McAnarney: The High Costs of the New Tax Laws

There has never been a time that our tax code has been more complex - even ignoring the Code's supporting cast of treasury regulations, IRS revenue rulings, revenue procedures, and a tax court system to interpret them all.

The number of new tax laws in recent years has been staggering.

In 2009 alone, the American Recovery and Reinvestment Act (ARRA) added hundreds of new provisions (American Opportunity Tax Credit, Economic Recovery Payments, Making Work Pay Credit, etc.) and changed many existing laws (count the American Opportunity Tax Credit again as a Hope Credit modification), first-time homebuyer credit, EITC, NOL carrybacks, etc.).

And we haven't even begun to mention tax law changes affecting businesses.

What does this explosion of tax laws mean for taxpayers and policy makers?

This is not a new problem, as tax laws have been expanding and growing in complexity for years - 15,000 changes to the Internal Revenue Code since the tax reform of 1986 [1] - equal to more than two changes each day. While the problem may not be a new one, its cost to society is onerous and growing. The tax gap, last estimated at $290 billion [2], is due largely to non-compliance, half of which is attributable to under-reporting of tax liability by individuals. The simplest tax system will still be a victim of taxpayers who willingly ignore the laws, hide income, or overstate deductions. However, the complexity of our tax system also contributes to noncompliance. IRS's program on matching information documents received to tax returns will help reduce the tax gap, but has no impact on simplification.

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Another effect on taxpayers is cost.

Even if an individual taxpayer prepares his or her own Form 1040 (which the IRS estimated to take 21.4 hours[3]), the cost of compliance is not trivial. Put simply, the cost to a taxpayer earning $25/hour to prepare his own tax return is $535. He can "save" almost $400 by having a tax preparer complete his return at an average cost of $166.[4]

Indeed, the tax preparation industry's growth may be attributed to the growing complexity of our tax laws. Tax professionals serve a legitimate need by helping millions of honest taxpayers who can no longer prepare their own tax returns, but at a great cost. The GAO estimated that in 2008, 85 percent of all individual income tax returns were prepared by a paid preparer or tax preparation software.[5] Estimates for the total cost of tax preparation do not include expenditures made by the industry for training and the continuing education required by tax preparers to keep up with the hundreds of tax law changes that occur every year.

This presents a challenge for tax policy makers.

Our tax system has always been a force in shaping desirable social behavior - encouraging home ownership, supporting families, obtaining an education, saving for retirement, etc. However, rather than a single set of common-sense laws that are comprehensible to those who must follow them, complexity is the rule, not the exception.

For example, encouraging taxpayers with tax benefits to become educated and contribute to our economic growth is sound tax policy. However, the tax code's complicated menu of education tax benefits is overwhelming, with its credits (Hope, American Opportunity, Lifelong Learning), deductions (tuition and fees, student loan interest), and exclusions (qualified bond interest) - not to mention qualified tuition plans.

Taxpayers hoping to ease the burden of high education costs through tax benefits face a complex set of rules for eligibility, qualified education expenses, distributions, and penalties for violations.

A similar situation exists with retirement savings.

Tax law that encourage taxpayers to save for retirement is good policy. However, complexity can obstruct those goals, and sometimes the goals overlap. Is it better to save for retirement, or to pay for an education? Consider the unfortunate taxpayer who takes an early distribution from his qualified plan to pay for his daughter's tuition. Not only must he pay tax on the distribution, but imagine the shock on his face when he learns that he is also subject to a penalty. Had he instead taken the distribution from his IRA, he would not have been penalized.

The myriad of retirement savings vehicles (traditional and Roth IRAs, 401(k)s, 403(b)s, SEP, SIMPLE plans, etc.) and their different rules for eligibility, contributions, phaseouts, distributions, and penalties - make it easy for taxpayers to ignore altogether - contrary to the policy lawmakers envisions when they forged such laws.

In her 2008 Annual Report to Congress, Nina Olson, the National Taxpayer Advocate, wrote that the "confounding complexity of the Internal Revenue Code is one of the most serious problems facing taxpayers."

Indeed, this has been a recurring theme in previous reports, but while the call for tax simplification continues, Congress is making great strides - but possibly in the opposite direction.

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Amy McAnarney, CPA, Executive Director, The Tax Institute at H&R Block