Can the IRS Scandal Shake the Dust Out of a Toxic Tax Code?

taxmanTo put it lightly, the U.S. tax code has become toxic. The standing document has been edited 5,000 times over the past dozen or so years and is nearly 4 million words long, or “10 times the size of the Bible with none of the good news,” as Representative David Camp (R-Mich.) would put it.

In 2011, the Laffer Center for Supply-Side Economics published a paper arguing that because of the gross complexity of the tax code, the costs incurred by taxpayers are actually far greater than the net sum that the government collects. The paper outlines how and why “individuals and businesses as taxpayers must pay substantially more than $1 in order for government beneficiaries to receive $1 of federal government services.”

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Using 2010 data, the Laffer Center calculated that “taxpayers pay $431.1 billion annually, or 30 percent of total income taxes collected, just to comply with and administer the U.S. tax system.” The primary component of that calculation includes the dollar value of the 6.1 billion hours (worth $377.9 billion) spent by individuals and businesses in complying with filing requirements. In other words, that’s a $378.9 billion cost to the U.S. economy in time spent doing paperwork alone.

The Laffer Center report necessarily makes some estimates in order to reach its conclusions, but it decides not to even take a stab at quantifying what it considers to be the highest cost of the byzantine U.S. tax system: the changes in business and taxpayer behavior that are the result of awkward and sometimes misguided tax incentives.

Corp-tax-schedule_1

Source: http://www.taxpolicycenter.org/briefing-book/key-elements/business/statutory.cfm

There is a first tier implication here that is clear: individuals and businesses respond to changes in tax policy by changing their behavior. A recent and popular example of this is Apple’s (NASDAQ:AAPL) decision to keep a signification portion of its cash overseas instead of moving it back into the U.S. Repatriation taxes are so unattractive that in order to finance a massive share repurchase program, the company decided to issue $17 billion in debt instead of transfer funds.

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A hundred years ago, Congress made interest on debt tax deductible as a means to incentivize private-sector activity such as capital-intensive expansions. The legislation has helped foster an environment of leveraged private-equity takeovers and has become a pillar of financial engineering in the U.S. Interest deductions on corporate debt totaled $422.7 billion in 2009, according to a study by Robert Pozen and Locas Goodman.

Lowering the corporate tax rate was a primary talking point of the 2012 presidential campaign, and the conversation has continued through the current fiscal debate. A thousand iterations of tax reform have been proposed and championed from both sides of the aisle, but progress has been slow at best. Broadening the tax base while eliminating special tax incentives has proven to be incredibly difficult.

Recent efforts to cap interest deductions have met heavy resistance from leading business and industry groups. Activist groups suggest that limiting deductions on interest rates will curb business investment and slow job growth. However, many of the same groups also argue that the high statutory corporate tax rate in the U.S. — 35 percent — inhibits competitiveness, because it has failed to decline alongside the average rate in other countries.

Statutory Tax

Source: Capping the Deductibility of Corporate Interest Expense by Robert Pozen and Lucas Goodman

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Lawmakers have been unwilling to lower the corporate tax rate because it would widen the deficit and create a funding gap that would be hard to plug without drastic spending cuts. The result is a sort of stalemate between the private sector and the government, where both would like to do what’s most economically desirable but are unwilling to cooperate on a solution.

Theoretically, workarounds to this conundrum exist. The Pozen-Goodman study proposes a revenue-neutral tradeoff that would lower the corporate tax rate from 35 to 25 percent by putting a 65 percent cap on interest deductions at non-financial corporations. This could ultimately be desirable to corporations in the current low-rate environment, but it’s unclear whether or not a change like this would be a better incentive (or less of a handicap) for business activity.

Getting back to the beginning of the discussion, there is a second-tier implication of awkward and sometimes misguided tax incentives. An outstanding example of this is the recent scandal involving the IRS seeking additional review of 501(Ϲ)(4) applications submitted by conservative groups simply because of ideology. There should of course be absolutely zero tolerance for political bias at America’s tax authority, but in hindsight the entire situation almost seemed inevitable.

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The narrative of what happened at the IRS’s tax-exempt division before and during the 2012 presidential election is still incomplete, but the a report from the Inspector General revealed what may accurately be described as institutional incompetence as the root of the problem. In a nutshell, after the 2010 Citizens United V. Federal Election Commission Supreme Court Decision, the IRS was flooded with 501(Ϲ)(4) applications because there was a tax incentive to do so, and the IRS was totally unprepared.

A majority of well-meaning organizations and a few bad actors trying to game the system were trying to take advantage of the benefits of being a 501(Ϲ)(4) organization. Citizens for Responsibility and Ethics in Washington filed a lawsuit against the IRS shortly after the scandal broke and articulated much of what is wrong with the system.

“As the ongoing IRS scandal shows, the 501(Ϲ)(4) regulation is unmanageable. It clearly conflicts with the Tax Code and IRS employees are simply at a loss as to how to apply it. Remarkably, the IRS has known the regulation presents enforcement issues for more than 50 years, but has failed to act,” said CREW Executive Director Melanie Sloan in a statement. “CREW has sued to force the IRS to finally deal with this issue.”

CREW argues that the language in the Tax Code grants tax-exempt status to groups who are “primarily engaged” in promoting social welfare. This has been interpreted to mean that an organization can exist as a tax-exempt 501(Ϲ)(4) and participate in electoral or political activities as long as those activities don’t consume more than 49 percent of annual expenditures. Meanwhile, separate tax laws require that such tax-exempt groups be “operated exclusively” for social welfare purposes.

This discrepancy, the potential for gamesmanship that it creates, and the difficulty in interpreting and enforcing the conflicting messages played a critical role in the targeting ordeal. IRS agents were tasked with determining the level of political activity of a wide range of groups, many of which fell somewhere on the spectrum of political engagement.

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So not only was there an incentive that misguidedly attracted a few bad actors that triggered Orange Alert at the IRS tax exempt division, but the gross complexity of the tax code and related regulatory framework created an environment that made it impossibly difficult to identify or deal with those bad actors. Reducing the complexity of the tax code and the regulations surrounding 501(Ϲ) organizations could go a long way in preventing something like this from happening again, not to mention simply streamlining the process and driving efficiency.

“There are countless political organizations at both ends of the spectrum masquerading as social welfare groups in order to skirt the tax code,” said Senate Finance Committee Chairman Max Baucus (D-Mont.). “Once the smoke of the current controversy clears, we need to examine the root of this issue and reform the nation’s vague tax laws pertaining to these groups.”

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