07 WFT IV-1, DD Inserts

Chapter 1 Digging Deeper

Contents:

CRITERIA USED IN THE SELECTIONOF A TAX STRUCTURE

1.In the eighteenth century, Adam Smith identified the following canons of taxation,which still should be considered when evaluating a particular tax structure.1

Equality. Each taxpayer enjoys fair or equitable treatment by paying taxes inproportion to hisor her income level. Ability to pay a tax is the measure ofhow equitably a tax is distributed among taxpayers.
Convenience. Administrative simplicity has long been valued in formulating tax policy. If a tax is easily assessed and collected and its administrative costs are low, it should be favored. An advantage of the withholding (pay-as-you-go) system is its convenience for taxpayers.
Certainty. A tax structure is good if the taxpayer can readily predict when, where, and how a tax will be levied. Individuals and businesses need to know the likely tax consequences of a particular type of transaction.
Economy. A good tax system involves only nominal collection costs by the government and minimal compliance costs on the part of the taxpayer. Although thegovernment’s cost of collecting Federal taxes amounts to less than 1 percent of the revenue collected, the complexity of our current tax structure imposes substantial taxpayer compliance costs.

By these canons, the Federal income tax is a contentious product. Equality ispresent as long asone accepts ability to pay as an ingredient of this component. Convenience exists due to a heavy reliance on pay-as-you-go procedures. Certaintyprobably generates the greatest controversy. In one sense, certainty is present sincea mass of administrative and judicial guidelines exists to aid in interpreting the taxlaw. In another sense, however, certainty does not exist since many questionsremain unanswered and frequent changes in the tax law by Congress lessen stability.

Economy is present if only the collection procedure of the IRS is considered.Economy is not present, however, if one focuses instead on taxpayer complianceefforts and costs.

In 2001, theAmerican Institute of Certified Public Accountants(AICPA) issued suggestions on Federal tax policy. TitledGuiding Principles of Good Tax Policy: A Framework for EvaluatingTax Proposals, the monograph sets forth 10 tax principlesthat are commonly used as indicators of desirable tax policy.

The first four principles are adapted from Adam Smith’sThe Wealth of Nations. The other six are summarized below. The full text of the monograph is available at .

The tax system should be simple.
The tax should be neutral in terms of its effect on businessdecisions.
The tax system should not reduce economic growth andefficiency.
The tax should be clear and readily understood, so thattaxpayers know about it and when it applies.
The tax should be structured so as to minimize noncompliance.
The tax system should enable the government to predict theamount and timing of revenue production.

WHO PAYS THE U.S. INCOME TAX?

2.There are plenty of commentators nowadays talking about how to “fix” the Federal income tax. Think tanks, op-ed columnists, and presidential hopefuls have released sometimes-elaborate plans for how the tax law should work.

Most agree that the alternative minimum tax needs a major adjustment, but there is little consensus on other details in the various plans. Some want to raise taxes on the wealthiest taxpayers by limiting deductions or repealing the Bush II tax cuts. Others are convinced that further tax cuts are needed—they want to make some temporary tax cuts permanent and repeal the estate tax outright. An unstated goal is to increase taxes in the “right” manner and timeliness to pay for the costs of a war and the rebuilding process in light of natural disasters.

Often, underlying assumptions about how the tax law should work are unstated or unclear. And the political motivations of the commentator are seldom far below the surface.

The Tax Foundation has issued a series of papers detailing some of the data that tax reformers should consider. Here are some of the highlights of their findings, most of which simply analyze publicly available IRS and Treasury data. For the full text of the papers, go to .

By most estimates, about ten percent of all potential taxpayers do not even file a tax return, because of insufficient income. These parties typically include the elderly, the young, and those in poverty.And another one-third of taxpayers (42.5 million of them) files a return and has no tax due. This means that all withholdings are returned to the taxpayer (ideally the taxpayer would have arranged with the employer to have zero withholding to begin with), and perhaps an earned income credit and refundable child tax credit attaches so as to pay more than the withheld amount to the filer. The Tax Foundation refers to these individuals as “non-payers” as opposed to the “non-filers.” Non-payers typically achieve such status by applying the child tax credit and various education deductions and credits. Steady increases in the standard deduction and personal exemptions, and the statutory relief from prior so-called marriage penalties create other non-payers. Here are some historical data about non-payers.

Tax Year / Tax Filers With a Zero Federal Income Tax Liability (%)
1950 / 28
1970 / 16
1978 / 26
1984 / 18
2006 / 41

Over half of the non-payers claim a refundable tax credit. In 2005, refundable earned income credits totaled about $37.5 billion, and the refundable portion of the child tax credit accounted for about $15.5 billion of payments. Because of the use of these refundable credits, the incidence of the Federal income tax burden is very low or negative for low-income taxpayers. Tax credits (probably purposely) decrease an already low tax burden at lower income levels, and the result is a redistribution of the tax burden to upper-income taxpayers.

IRS and Census data find that current non-payers tend to be:
Low income (97% earn < $40,000 per year)
Young (36% are < age 25; 56% are < age 35)
Women and unmarried (54% are single women or female-headed households)

2006: Estimated Filing Status of Federal Income Tax Non-Payers
Filing Status / % in Filing Status That Are Non-Payers / % of All Non-Payers
Single / 33.1 / 42.2
Married, Joint Return / 21.5 / 29.8
Married, Separate Return / 21.6 / 1.2
Head of Household / 65.7 / 26.6

Combined, non-filers and non-payers total about 43.5 million tax returns annually. Because of the use of joint returns, the Tax Foundation estimates that this figure represents about 121 million citizens, about 41 percent of the total US population, who are “outside of the Federal income tax system” (i.e., they paid no income tax to the Federal government at all).This may represent the will of the voters, and it may be good government policy as to taxes, poverty, and employment. But is it wise in a civic-mindedness sense to have so many individuals making no contribution to the operations of the government? How about a “minimum income tax” so that all citizens are required to contribute some amount to support government operations?

It is true that the non-filers and non-payers do contribute to the Federal government through payroll, alcohol, and gasoline taxes, and to state and local governments through sales/use and property taxes on housing. But most voters have no idea how skewed is the current distribution of the Federal tax burden. It is important to disseminate this information on tax incidence, and also to measure the effects of low or negative contributions to the system on one’s attitude toward government and fellow citizens. The Tax Foundation paper makes the same point.

While some may applaud the fact that millions of low- and middle-income families pay no income taxes, there is a threat to the fabric of our democracy when so many Americans are not only disconnected from the costs of government but are net consumers of government benefits. The conditions are ripe for social conflict if these voters begin to demand more government benefits because they know others will bear the costs.

PROPOSED U.S. TAXES

3.Considerable dissatisfaction with the U.S. Federal income tax has led to several recent proposals that, to say the least, are rather drastic in nature. One proposal would retain the income tax but with substantial change. Two other proposals would replace the Federal income tax with an entirely different system of taxation.

The Flat Tax

One proposal is for a flat tax that would replace the current graduatedincome tax with a single rate of 17 percent. Large personal exemptions (e.g.,approximately $30,000 for a family of four) would allow many low- and middleincometaxpayers to pay no tax. All other deductions would be eliminated, and notax would be imposed on income from investments.

Various other versions of the flat tax have been suggested that would retainselected deductions (e.g., interest on home mortgages and charitable contributions)and not exclude all investment income from taxation.

The major advantage of the flat tax is its simplicity. Everyone agrees that thecurrent Federal income tax is unbelievably complex. Consequently, compliancecosts are disproportionately high. Proponents of the flat tax further believe that simplifying the income tax will significantly reduce the annual $300 billion “tax gap” (i.e., the difference between the amount of taxes that should be paid and what is actually paid).

Political considerations are a major obstacle to the enactment of a flat tax in itspure form. Special interest groups, such as charitable organizations and mortgagecompanies, are not apt to be complacent over the elimination of a tax deductionthat benefits their industry. In addition, there is uncertainty as to the economiceffects of the tax.

It is interesting to note that Russia’s attempt at a progressive income tax wassomewhat disastrous. Not only did high rates drive capital out of the country, but failure to report income was rampant. The income tax was repealedand replaced with a 13 percent flat tax. To date, the flat tax has worked quite well.Several Baltic states (Estonia, Latvia, and Lithuania) have followed Russia’s example.Romania, Albania, Slovakia, Georgia, Ukraine, and Serbia have also adopted a flat tax.

TAX ADMINISTRATION

4.The responsibility for administering the Federal tax laws rests with the TreasuryDepartment. Administratively, the IRS is part of the Department of the Treasuryand is responsible for enforcing the tax laws. The Commissioner of Internal Revenueis appointed by the President and is responsible for establishing policy andsupervising the activities of the entire IRS organization.

The Audit Process

Selection of Returns for Audit. Due to budgetary limitations, only a smallminority of tax returns are audited. The IRS audits only about 1 percent of all individual income tax returns (about onein every 103 returns filed). Nevertheless, the number of individual income taxreturns being audited has increased significantly over the past five years.

The IRS utilizes mathematical formulas and statistical sampling techniques toselect tax returns that are most likely to contain errors and to yield substantialamounts of additional tax revenues upon audit. The mathematical formula yieldswhat is called a Discriminant Information Function (DIF) score. It is the DIF scoregiven to a particular return that may lead to its selection for audit.

To update the DIF components, the IRS selects a cross section of returns, whichare subject to various degrees of inspection (i.e., information return verification,correspondence, and face-to-face audits with filers). The results of these auditshighlight areas of taxpayer noncompliance and enable the IRS to use its auditorsmore productively. In recent years, IRS audits have resulted in an increasing numberof ‘‘no change’’ results (see below). This indicates that the IRS is not alwayschoosing the right returns to audit (i.e., the ones with errors).

Though the IRS does not openly disclose all of its audit selection techniques,the following observations may be made concerning the probability of selection foraudit.

Certain groups of taxpayers are subject to audit much more frequently than others. These groups include individuals with large amounts of gross income, self-employed individuals with substantial business income and deductions, and taxpayers with prior tax deficiencies. Also vulnerable are cash businesses (e.g., cafe´s and small service businesses) where the potential for tax avoidance is high.

Example:Jack owns and operates a liquor store on a cash-and-carry basis. Since all of Jack’s sales are for cash, he might well be a prime candidate for an audit by the IRS. Cash transactions are easier to conceal than those made on credit.

If information returns (e.g., Form 1099, Form W–2) are not in substantial agreement with reported income, an audit can be anticipated.
If an individual’s itemized deductions are in excess of norms established for various income levels, the probability of an audit is increased.
Filing of a refund claim by the taxpayer may prompt an audit of the return.
Information obtained from other sources (e.g., informants, news items) may lead to an audit. Recently, for example, the IRS advised its agents by Internet to be on the alert for newspaper accounts of large civil court judgments. The advice was based on the assumption that many successful plaintiffs were not reporting as income the punitive damages portion of awards, which is taxable.

The tax law permits the IRS to pay rewards to persons who provide informationthat leads to the detection and punishment of those who violate the tax laws. Therewards may not exceed 15 percent of the taxes, fines, and penalties recovered as aresult of such information.

Example: After 15 years of service, Rita is discharged by her employer, Dr. Smith. Shortly thereafter, the IRS receives an anonymous letter stating that Dr. Smith keeps two separate sets of books, one of which substantially understates his cash receipts.

Example:During a divorce proceeding, it is revealed that Leo, a public official, kept large amounts of cash in a shoe box at home. This information is widely disseminated by the news media and comes to the attention of the IRS. Needless to say, the IRS would be interested in knowing whether these funds originated from a taxable source and, if so, whether they were reported on Leo’s income tax returns.

Types of Audits. Once a return is selected for audit, the taxpayer is notified. Ifthe issue involved is minor, the matter often can be resolved simply by correspondence(a correspondence audit) between the IRS and the taxpayer.

Example:During 2008, Janet received dividend income from Green Corporation. In early 2009, Green Corporation reported the payment on Form 1099–DIV (an information return for reporting dividend payments), the original being sent to the IRS and a copy to Janet. When preparing her income tax return for 2008, Janet apparently overlooked this particular Form 1099–DIV and failed to include the dividend on Schedule B, Interest and Dividend Income, of Form 1040. In 2010, the IRS sends a notice to Janet calling her attention to the omission and requesting a remittance for additional tax, interest, and penalty. Janet promptly mails a check to the IRS for the requested amount, and the matter is closed.

Other examinations are generally classified as either office audits or fieldaudits. An office audit usually is restricted in scope and is conducted in the facilitiesof the IRS. In contrast, a field audit involves an examination of numerous itemsreported on the return and is conducted on the premises of the taxpayer or the taxpayer’srepresentative.

Upon the conclusion of the audit, the examining agent issues a RevenueAgent’s Report (RAR) that summarizes the findings. The RAR will result in arefund (the tax was overpaid), a deficiency (the tax was underpaid), or a no change(the tax was correct) finding. If, during the course of an audit, a special agentaccompanies (or takes over from) the regular auditor, this means the IRS suspectsfraud. If the matter has progressed to an investigation for fraud, the taxpayershould retain competent counsel.

Notes:

1The Wealth of Nations, Book V, Chapter II, Part II (Dutton, New York: 1910).