Over the past few years we have seen enough tax law changes for one lifetime. From the Tax Cuts and Jobs Act to the CARES Act, it seems like taxes are getting more and more complicated. I swear, every year that goes by I learn of new filing requirements and new forms that clients need to fill out. But why does it have to be this way?
There are a few competing theories why our tax system is so complicated but there are 3 popular theories that prevail:
The Tax Prep Industry Makes Money From Complexity – One of the leading theories behind tax law complexity is the influence of lobbyist in the tax prep industry. The theory goes that large companies like TurboTax and H&R Block have the most to lose from a simple tax code. Imagine the lost revenue for these companies if taxpayers can file their taxes automatically with ease.
Government Incompetence or Over-competence – Another leading theory is focused around the Treasury Department, specifically the IRS. Some would argue that government incompetence (or over-competence) leads to well intentioned individuals with no real world experience who write the rules regarding how we pay taxes. If you read some of these code sections you might agree.
Large Corporations Push for Complexity to Avoid Paying Taxes – Lastly, this third theory blames tax code complexity on large corporations that hire expensive tax lawyers to circumvent the rules in an attempt to avoid paying taxes. To prevent these corporations from bending the rules Congress has to step in from time to time to clamp down on these tax shelters. After a few decades of playing cat and mouse you can imagine the mess we’ve made.
The root of the issue surrounding tax complexity can’t be pinned to a single theory but instead to a combination of all three. However, the theories alone only describe the symptoms and not the underlying cause. To unveil the true reason behind tax complexity you have to look at how we tax ourselves.
The Real Reason Behind Tax Complexity
The real reason why our tax system is so complicated is because we tax income; even more so, we tax income preferentially. To make this easy to understand let’s look at some of the ways we classify income and the different ways we tax it.
Wages – Wages are subject to a variety of taxes including federal, state and local taxes. Wage earners pay federal income tax, social security tax, medicare tax as well as taxes based on where they live and where they work. On top of these taxes the wage earner’s employer will also have to pay matching social security taxes, federal unemployment and state unemployment taxes.
Business Income – Business owners have a variety of options on how they can operate their business and therefore have several options on how those businesses are taxed. If the owner runs the business though a passthrough entity then they’ll pay taxes similar to wage earners with a few exceptions. If they run the business as a C-Corporation then they’ll be subject to different rules and different rates along with taxes on any profits that are distributed to the owners.
Investors – Passive investors who buy stocks, bonds, business interests and other investments have a completely different system of taxation. Their income might be subject to preferential rates that are considerably lower than wage owners and business owners and can avoid employment taxes altogether. Some investments are so preferential that they aren’t taxed at all.
This system of taxation may seem appropriate for a capitalist system because it separates segments of taxpayers based on their role in the overall economy, however, as we’ll soon find out, this system of taxation creates complexity.
The root of tax complexity lies in the taxation of income but the trunk, branches, and leaves all spring from the need to create incentives. How do we get workers to save for retirement? How do we get business owners to invest in productive industries? How do we get investors to put money into underdeveloped communities?
In an attempt to create rewards for good economic behavior the federal government gives out deductions, credits and exclusions from gross income to worthy taxpayers. These incentives range from having children, buying solar panels, saving for retirement, investing in research and development, so on and so forth.
For each incentive you need rules, exception to the rules, limitations and administrative guidance to help taxpayers navigate the tax law. The more incentives you build into the code the more complex you make the tax code and the more governmental staff you’ll need to audit for ineligible claims or fraud.
As with any game, if you don’t have a rule against a specific action you would assume it’s not a violation of the rules. A good portion of the tax code is to address transactions and reporting scenarios where the code is silent.
These code sections prevent taxpayers from shifting income from their return to their children’s return to avoid high tax rates (kiddie tax rules). They prevent taxpayers from deducting losses from businesses they don’t actively participate in (passive activity loss limitations). They go as far as preventing related parties from making transactions that would significantly alter their tax liabilities (related party transaction rules).
Putting it All Together
So why is the tax code so complicated? Why does it take lawyers, accountants and financial advisors just to make simple everyday business and economic decisions? It’s because we’re taxing your economic decisions in such a disparate manner.
For other forms of tax it’s quite simple. If you want to buy food you’ll pay sales tax at a specific rate. You want to live in a certain school district you’ll need to pay real estate taxes based on the home’s value. Most of these taxes don’t require much if any calculation on the part of the taxpayer and is easily collected.
But for income taxes, both federal, state and local, the situation is vastly different. With the various credits, deductions, exemptions and preferential treatment of specific income items it’s no wonder why it feels as if you need a law degree just to file your own taxes.
The information contained herein is is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined though consultation with your tax adviser. This article represents the views of the author only and does not necessarily represent the views or professional advice of this publication or the author’s employer.