Tax Fantasies

Sac Bee Cartoon - not related to the story

The Bee had a story yesterday titled "If Taxpayers Paid Up, the Deficit Would Disappear."   The Franchise Tax Board has estimated that $10 billion in state taxes go unpaid and the Board of Equalization estimates that an additional $2.3 billion in sales taxes do not get paid.  Were this true it would be a major story, but chalk this one up to absurd assumptions - fantasy.

Here are some claims made by tax analysts.  #1 - The Legislative Analyst found in a report that wage income gets reported about 90% of the time if it is withheld and only about 70% if it the tax is not withheld.     That might be close to correct.  The 10% breach on withheld income should get caught if the FTB is efficient - but a 90% compliance rate is pretty darn good.   I suspect that if one were able to separate out all the gray money payments that the non-withheld income gets reported at about the same rate.  In other words a lot of the non-reported income comes from things like drug deals.  The tax agencies claim they do not count illegal activity in the under-reporting statistics but that is a questionable claim.

#2 - A federal study found an 83.6% compliance rate (which in my estimation is still pretty good) for paying taxes that are due.  The federal study found that the major cause of under-reporting was precipitated by a small amount of direct fraud and a larger percentage of what they described as under-reporting.  Sure there are taxpayers who claim outrageous amounts for donations of used goods (even some former presidents) but those losses are minor.  There may be some evasion but I think a lot of the problem comes from complexity - it is hard to know what is the right thing to do.

#3 - The USE tax - under California law a taxpayer is required to pay the equivalent sales tax on something which was bought outside the state.    Tax agencies count that as evasion.  Saner people argue that taxes should not follow you anywhere.  The Use Tax concept is confused (and confusing).

Perfect tax compliance is a fantasy.  It began to be talked about when Stanley Surrey (President Johnson's Assistant Secretary for Tax Policy) began to formulate the notion of "tax expenditures."   That idea posited that just like appropriations we could track the value of changes in the tax code from an "ideal" frontier as if they were cash - were they not in the code the government would receive more dough.  The problem with the theory is that is needs to assume that all wealth is created by government.   While some people believe that no thinking person does.   At about the same time that Surrey was writing all the rage in tax was a book by Nicholas Kaldor (An Expenditure Tax) which argued that the most perfect tax system would count all flows into and out of a person (for example, the increase in valuation of one's house).  Amazon's summary says "This work explores the idea that the taxation of individuals should be based upon their expenditure, not on their income. It argues that if progressive taxation were levied this way, we could move towards an egalitarian society and improve efficiency and the progress of the economy."  The book was great theory but impossible to implement in real life.

Kaldor even had some influence on the task force that President Reagan convened at the beginning of the process that resulted in the 1986 Tax Reform Act.   In the first draft of the Bluebook (which was the comprehensive proposal for the changes) a Kaldoresque proposal was present for home appreciation.  Reagan and other politicians quickly realized that would not fly politically.

So what can we say about tax compliance and how to improve it?   First, government officials should assume there will always be some inefficiency in any system.   It is not possible (and probably not desirable) to get 100% compliance.  It is silly to assume that if everyone paid their "fair share" in taxes that the deficit(s) would be eliminated - the deficits come primarily from spending not from revenues.   If we matched our spending with our revenues we would not have a problem - but we don't.

Second, simplicity breeds compliance.   By simplifying the tax system (especially in the income tax) more people are likely to comply.   Tax loss carry forwards may look like good politics but they are terrible for conformity.

Third, the integration of data systems (the article mentions that the FTB matches no income tax filings with car registrations surmising that if you register a $100,000 car with no income, you probably are doing a bit of fudging) will continue and should help to assure that compliance is as good as it can be.