November 8, 1996
Co-Chairman, and members of this distinguished commission, I am Michael E. Mares, chair of the Tax Division of the American Institute of Certified Public Accountants (AICPA). The AICPA is the national, professional organization of certified public accountants comprised of more than 325,000 members who advise clients on Federal, state and international tax matters as well as prepare income and other tax returns for millions of Americans. Our members provide services to individuals, not-for-profit organizations, small and medium-size businesses, as well as America's major businesses, including multi-national corporations. Many serve businesses as employees. It is from this base of experience that we offer our comments.
This testimony is focused on the complexity in the tax law and the indicators to bring simplification into consideration during the tax legislative process. In early 1990, the AICPA Tax Division released its Blueprint for Tax Simplification which attempts to define the tax complexity problem, defines the factors that affect complexity, discusses the development and use of simplification measurement tools, and sets forth guiding principles for simplification. Shortly after the release of the Blueprint, the Tax Division issued in draft form the Tax Complexity Index as a sample measurement tool to be used to assess the relative complexity, or simplification, of proposed tax law changes. In addition, in early 1990, the AICPA jointly sponsored the Invitational Conference on Reduction of Income Tax Complexity which brought together tax policy experts for two days of presentations and discussion of the major factors contributing to the increased complexity of the tax law and possible solutions to the resulting problems. Throughout the years, the Tax Division has offered an extensive number of recommendations aimed at simplifying unduly complex areas of the tax law and has made consideration of tax simplification an integral part of the development of any tax legislative or regulatory submission. It is from these efforts that I draw my comments today.
A. The Problem
Tax legislation of increasing magnitude and complexity is being passed by the U.S. Congress virtually every year. In 1996 alone, four significant tax acts were passed by Congress: the Small Business Job Protection Act, the Taxpayer Bill of Rights, Health Insurance Portability and Accountability Act, and the Personal Responsibility and Work Opportunity Reconciliation Act. The Internal Revenue Code (IRC or the Code) now contains many extraordinarily complex provisions. The Treasury regulations interpreting those provisions likewise have become increasingly complex. The frequency and scope of legislation make it very difficult for the Treasury Department to issue timely and adequate guidance. As time passes, taxpayers, their advisers, and the Internal Revenue Service (IRS) face increasing uncertainty as to the correct tax treatment of an item.
The cornerstone of tax administration in the United States is a voluntary tax compliance system. Voluntary compliance depends on both the ability and the willingness of taxpayers to comply. Further, it depends on the ability of tax practitioners to understand and properly advise taxpayers. Needless complexity erodes this system because full compliance increasingly requires an unreasonable outlay of effort and resources. Some taxpayers believe the IRS is incapable of discovering noncompliance. A few have the impression that understanding the tax laws will only serve to increase the amount of taxes they must pay. As a result, there is growing resistance by taxpayers to take the steps necessary to fully comply. Furthermore, complexity adds to the perception of unfairness. Taxpayers who do not understand the tax rules that apply to them often think they are being dealt with unfairly and that some taxpayers have benefits not available to others.
Complexity interferes with business decisions by making the after-tax economics of transactions less certain. Furthermore, some observers express concern that the compliance burden borne by taxpayers and the IRS diverts resources from more productive endeavors.
A tax system that is simple for all taxpayers may never be designed, but a simpler tax system is a critical and achievable goal. The problem of an overly complex tax system has arisen in part because of the dominance of other legislative goals, such as revenue enhancement, rate reduction, and economic and social policy. By working within the constraints imposed by the need to balance the various objectives of the tax system, it will be possible to design a simpler tax system.
To achieve the goal of a simpler tax system principles to guide the design of a simpler tax system must be established and the major factors that contribute to complexity must be identified. This can promote the development of a simpler tax law by revealing opportunities for simplification and by providing a framework for a cost-benefit analysis that considers revenue, equity, and policy objectives as well as simplification. Also, consideration of the simplification aspects of a proposal must occur at all stages of the legislative process. Changes must be made in the process to provide adequate time for a thorough consideration of tax proposals, including simplification options.
B. Need for a Constituency
Many members of Congress, tax professionals, and the general public have begun to actively support simplification initiatives. The appointment of The National Commission on Restructuring the Internal Revenue Service and the recent debate about alternative tax systems, such as the consumption tax and flat tax, are indications that a simplification constituency exists. However, the development of an even stronger voice for simplification is necessary if simplification is to become an integral part of the legislative and regulatory process. The natural constituents for tax simplification are taxpayers, tax practitioners, and tax administrators.
To achieve a simpler tax system, there must be organized demand from all interested parties. The degree of complexity of the tax system indicates that the demand for tax simplification, in the past, has been insufficient. A successful simplification initiative
must be driven by committed leadership that continues to demonstrate the benefits of simplification and maintains the priority of those benefits in any legislative initiative.
Simplification yields a number of benefits. Economic resources will become available for more productive endeavors. Taxpayers will be more willing and able to comply when they can understand their tax responsibilities. Further, taxpayers' confusion, frustration, and the psychological burden of dealing with their responsibilities will be reduced.
C. Guiding Principles for Simplification
In pursuing a simpler tax law, the following guiding principles should be considered:
D. Factors that Affect Complexity
An important step in simplifying the tax system is identification of the factors that create complexity. The factors fall into three categories: general factors; specific factors; and external factors that affect the tax system. Included with each factor are indicators of complexity which provide some measure of positive and negative influences.
1. General Factors
a. Complexity Due to the Effects of Change
Change in itself creates complexity for all affected parties. This is true whether the change results from an attempt to simplify existing provisions or from the addition of new tax concepts. Change causes complexity because there is necessarily a learning curve in mastering new rules. Transition rules create particular concern because the rules that must be learned are, by definition, temporary. The instability caused by frequent changes in the tax law in fact makes the law more complex, because affected parties must learn and apply different rules for different tax periods. Furthermore, the instability increases the perception of complexity for many taxpayers. It must be recognized that continued change within an area of the law creates complexity even where isolated provisions are not complex. Depreciation is a good example.
This does not suggest that policy considerations calling for change should never be allowed to override complexity concerns. Tax policy must continue to be an important element in any decision. Nor does it imply that change cannot, on balance, make a contribution to simplification or that transition rules are never justified. A change may ultimately result in less complexity because it eliminates difficult, unworkable, or complex rules; equity may demand that taxpayers have access to favorable transition rules despite the attendant complexity. The concern is that the goal of simplification requires that the long-term benefits of a change in the law be weighed against the complexity created by the change.
Effective dates for change also have an impact on complexity. For example, the 1996 Small Business Job Protections Act alone contained over 30 different effective dates, including many retroactive dates. Prospective provisions give taxpayers time to learn about the change and adapt to it. In cases where there are multiple changes, using the same effective date for all changes simplifies their implementation. Last minute tax law changes provide insufficient time for tax administrators, tax practitioners, and taxpayers to fully understand and implement the new rules.
Indicators for Tax Simplification
b. Complexity Caused by Subjectivity
To the extent that a provision is objective, or is determined by means of an objective test, it will be less complex. Despite the appeal of this general proposition, some provisions or concepts are inherently subjective in nature and not readily amenable to quantification in an objective test. Examples are trade or business and ordinary and necessary. The conditions necessary to satisfy the criteria for these concepts have become more predictable over time because of extensive administrative and judicial interpretation. However, this predictability only holds for those with significant training and experience in tax law.
Other subjective provisions are so dependent on facts and circumstances that even extensive interpretation and litigation have not been sufficient to yield a high degree of certainty in the law. An example would be the requirement that compensation be "reasonable" to be deductible. Significant time and effort continue to be spent by experienced practitioners on planning to avoid the adverse consequences of "excessive" compensation.
Some attempts to lend more certainty to the law by introducing objective standards to clarify a subjective term have increased complexity. For example, substantial economic effect and material participation are defined largely by numerous examples, and interest deductibility must be determined by wading through pages of rules. Too much detail can result in tax traps. Thus, while introducing some objective standards can further simplification, an overload of objectivity creates its own form of complexity.
Indicators for Tax Simplification
c. Lack of Consistent Concepts
To the extent that tax provisions are arbitrary and not consistent with traditional economic, accounting, or tax theories, they become much more complex because they cannot be derived logically and therefore must be memorized.
Consistency should be a goal of our tax system. Tax principles and consistent concepts have become vulnerable due to continual legislative changes, perceived abuses, and budget pressures. Many limitations enacted to prevent abuse add further complexity and diverge from basic tax principles. Provisions that require new record keeping systems (such as the alternative minimum tax [AMT] depreciation and uniform capitalization of inventory costs) contribute to complexity.
Indicators for Tax Simplification
d. Structural Complexity
The structure of the tax law creates complexity beyond that associated with specific Code provisions. The different treatment accorded capital gains and losses and ordinary income and losses is one example of structural complexity. Interactions between various Code sections and the use of cross-referencing also create substantial complexity. For example, the owner of "listed property" must first understand the rules for cost recovery in IRC section 168 and then recognize the impact of the IRC section 280F provisions on cost recovery calculations.
The introduction and codification of new concepts add to structural complexity. For example, the alternative minimum tax (AMT) introduced many new concepts and produces a great deal of interaction with existing regular tax provisions. The AMT significantly increases the number of taxpayer choices and makes the selection of appropriate planning and compliance strategies much more difficult. In other instances, new meanings are assigned to familiar, long-used terms. For example, the word passive retains its historical general meaning of unearned but now is also used in a much more technical sense in IRC section 469. Lack of statutory definitions of phrases, such as, trade or business and earnings and profits, and the accompanying reliance on regulations and case law, permit flexibility but also increase complexity. Multiple sets of rules in the Code (e.g., those governing attribution of ownership) suggest that horizontal drafting should be employed as frequently as possible.
Indicators for Tax Simplification
e. Effect on Taxpayers Not Targeted by a Particular Provision
Provisions targeted primarily at taxpayers with complex tax situations, who are often better able to afford extensive tax advice and return preparation, often create substantial and unintended problems for less sophisticated taxpayers. There may be situations in which a burden has to be placed on many taxpayers in order to provide reasonable treatment for the targeted taxpayers. The use of thresholds and safe harbors can alleviate this problem, but sometimes it can create others.
Since ignorance of the law has never been considered an acceptable reason not to comply, knowledge is required of all taxpayers, whether or not they are affected by a particular provision. Thus, while a safe harbor may in the end exempt a taxpayer, it is the taxpayer who incurs the additional compliance burden of determining whether or not a particular provision applies and whether a safe harbor can be invoked.
Furthermore, a sense of unfairness results from the "cliff effect" of a threshold or safe harbor, by which a taxpayer just misses qualifying. Phasing the rules in and out increases the perception of fairness but adds complexity to the calculations required.
A taxpayer may learn the law, keep the necessary records, and perform the required calculations, only to find that the threshold exceeds the amounts he or she has calculated, as in the case of miscellaneous itemized or medical deductions. Another taxpayer may fail to keep records and forgo deductions because of the perceived compliance burden.
On the other hand, many less sophisticated taxpayers must keep track of depreciation and basis for AMT purposes, even though they may never actually find themselves subject to the alternative minimum tax. In instances such as this, income thresholds would help reduce the record keeping burden.
Indicators for Tax Simplification
2. Contributing Factors
a. Communication Complexity
The Code is replete with terms of art. In many cases, a term of art (e.g., related party) is defined differently for different purposes. The structure of the Code itself, and cross references between Code sections, make interpretation difficult.
Throughout the Code, terms are used that are not clearly defined for all contexts or that may have more than one meaning. For example, the term related taxpayer has one meaning in IRC section 267 and another in the mitigation provisions of IRC section 1313. Differences between concepts such as controlled groups and affiliated groups are also hard to grasp. Definitions of the same or similar words also differ among the various types of taxes.
It is difficult to apply a relatively straightforward term such as earned income in light of the increasing complexity of our tax structure. Furthermore, a long-established term such as adjusted gross income becomes more confusing when, in certain situations, modified adjusted gross income must be computed (e.g., when a taxpayer has rental real estate activities, computes individual estimated tax payments, or may be subject to tax on social security benefits).
The cross-referencing from one Code section to another is also difficult at times. For instance, in computing the allowable exclusion for employer-provided child-care assistance under IRC section 129(b)(2), the special limitation on income for a student spouse contained in IRC section 21(d)(2) is often overlooked by the tax planner, who simply sees a $5,000 limit in the body of IRC section 129. Some of the complexity associated with cross-references could be eliminated if the Code consistently included a brief description of the interacting provision, as well as the Code section reference.
Indicators for Tax Simplification
b. Computational Complexity
The determination of taxable income and net tax liability is essentially a mathematical process. Therefore, any self-assessment system, no matter how simple, requires taxpayers to make calculations. For decades, the number of necessary tax calculations has increased steadily. For many taxpayers, these computations are now excessively complex and often redundant.
With each new tax law, the IRS has to add lines to old forms, design new forms, and insert additional worksheets into the instructions to assist taxpayers in making mandated computations. Businesses have to develop and maintain extensive data bases to comply with new rules (e.g., for inventories, depreciable assets, and pensions).
Computational complexity is generally introduced into the law with the intention of enhancing equity. Congress enacted the earned income credit to benefit the working poor. Although this provision applies to only a small segment of the population, it is historically the most error-prone line item on individual tax returns. The target population unfortunately has difficulty making the required computations.
As income levels rise the tax benefits of various deductions and credits are removed, generally in the name of equity, but increasingly for revenue purposes. Deduction and credit limits or phaseouts, as well as the numerous recalculations required by the alternative minimum tax, definitely increase computational complexity. They also increase the probability that calculations will be incorrect or overlooked.
In certain instances, the Code allows optional methods of calculation that, in theory, are simpler. Their presence merely injects another layer of computational complexity. Taxpayers will perform both the regular and optional calculations to determine the most advantageous method of reporting. The allowance of optional calculations should be the exception to the rule.
Advances in technology mitigate some of the impact of computational complexity. Computers can now maintain the multitude of depreciation schedules required for tax purposes. They also perform the calculations mandated by the uniform capitalization of inventory costs and adjusted current earnings rules. Lawmakers seem to have made the tacit assumption that they can add redundant sets of calculations which, because computers can handle them, will not increase complexity. Unfortunately, computers, software, and competent computer staff are expensive resources that most individuals and some businesses cannot afford. In addition, new software must be developed and purchased whenever the tax law changes.
This again raises the fundamental cost-benefit issue. Can income not be measured and the tax liability assessed in an equitable manner without so many costly and confusing computations?
Indicators for Tax Simplification
c. Complexity of Forms
Compliance behavior is a direct function of taxpayers' ability to understand their obligations and to correctly report tax-relevant transactions. Therefore, tax forms, instructions, and publications are a critical link between the tax laws and compliance by taxpayers. These materials themselves affect the complexity faced by taxpayers. They also have a direct impact on effective administration by the IRS. Legislative sensitivity to the manner in which tax law provisions must be implemented is the foundation of effective communication of compliance responsibilities to taxpayers.
In structuring tax forms, the IRS must continue to strive for the most user-friendly products: using familiar words and terminology, limiting the request for information to necessary for accurate reporting, and being well organized and easy to read.
The ability to reduce complexity in these materials is constrained because the forms must implement statutory requirements. For example, the form implementing the 1986 Tax Reform Act treatment of home mortgage interest had to incorporate calculations of deductible interest on acquisition indebtedness as well as on home equity loans for medical and educational expenditures. In addition, the form had to accommodate special calculations for grandfathered debt and the cost-basis ceiling for new acquisition indebtedness. Congress subsequently simplified the limitation on the deductibility of home mortgage interest, removing the need for a separate form altogether. This revision would not have been necessary had Congress appreciated the reporting difficulties involved in its initial proposal.
The forms and instructions for calculating the earned income credit are another example. To complete one line on Form 1040 or Form 1040A, a taxpayer may need to read three pages or more of instructions, complete three worksheets, refer at least twice to an agate type table, and complete a supplementary schedule. The required computations are very difficult and involve alternative calculations. This is a particularly perplexing problem because the affected taxpayers are those with the lowest income, the group least able to comply, because of lack of education and resources to pay for professional assistance.
Indicators for Tax Simplification
d. Administrative Complexity
New legislation places new demands on the administrative resources of the IRS and Treasury Department. The most immediate impact is felt in the task of redesigning tax forms and instructions to incorporate the changes. Interpretation of the law through regulations and rulings is necessary and may require revision of the recently issued forms. It may be difficult or impossible to issue timely guidance before effective dates. IRS personnel must become acquainted with new law promptly to provide guidance to taxpayers seeking to comply. Often they must be fully conversant with several conflicting provisions governing the same area (e.g., interest deductibility rules before 1987 and tracing rules after 1986) in order to perform the audit function.
The effort to achieve the highest possible level of certainty has historically caused the Treasury Department and the Internal Revenue Service to write detailed regulations that attempt to address all issues. This pattern has often caused delays in providing general guidance to taxpayers. The drafting of exhaustive regulations creates added complexity and a tremendous compliance burden for the small taxpayer. An example was the original proposed passive loss regulation defining the term "activity" which, for all but the most sophisticated taxpayers, was incomprehensible and nonworkable. We applaud Treasuryís and the IRS' reissuance of simpler regulations in this area and encourage efforts to seek opportunities to simplify other regulations in a similar manner, such as they have done with section 7701. Naturally, we realize certain tax areas demand specific, detailed regulations.
Taxpayers and the IRS alike have difficulty interpreting complex provisions. In addition, the IRS faces an even greater burden than taxpayers when factual issues are involved because taxpayers are in control of the reporting and presentation of facts relevant to a particular issue. For example, enforcing the research and experimentation credit is an extremely difficult task for the IRS because of problems in tracing and categorizing various expenditures and in judging whether the taxpayer meets requirements such as "technological innovation." Likewise, enforcing the luxury excise tax rules is difficult because of problems in identifying taxable transactions.
Complexity in making factual determinations is dramatically reduced from an administrative perspective to the extent that a provision relies on the interaction of two parties with contrary or adverse interests. For example, contracts for the sale of assets or an entire business are the result of pressure to establish the true purchase price; each party has tax and non-tax incentives to correctly state the agreed-upon price in the contract and purchase price allocation. These conflicting interests do not afford perfect controls, but they aid in verification.
Indicators for Tax Simplification
3. External Factors that Affect the Tax System
a. Legal Complexity
The legal environment creates certain complexities outside the control of the tax system. For example, the law regarding partnerships affects the allocation of partnership debt to individual partners, community property laws necessitate rate schedule changes to achieve parity among the states, and legal rights of ownership affect the transfer tax statutes.
b. Transactional Complexity and Business Dynamics
Some transactions are inherently complex. In many cases, the complexity of the transaction will necessitate complexities in the governing statute and regulations. Similarly, technological changes in the communication of business transactions in the global marketplace, as well as the proliferation of new financial instruments and transactions, result in additional complexity as new laws, rules, and regulations are promulgated to cope with the changes.
c. Diffusion of Responsibility
Because responsibility for the problems and costs of complexity is not specifically assigned within Congressional staffs, the Treasury Department, or the IRS, there is no accountability for these effects. Thus, there is no strong incentive for anyone involved in the legislative or administrative process to tackle the problem as a priority. A focused responsibility for simplification should be mandated.
d. Inconsistent Application of Rules
The multiple jurisdictions and levels of the courts lead to uncertainty because of different applications and interpretations of rules. The fact that state and local tax rules may dramatically differ from the federal rules increases complexity exponentially.
e. The Legislative Process
Complexity often is compounded by imperfections in the legislative process that make adequate deliberation impossible. The process must allow sufficient time to evaluate how well a proposal meets the goal of simplification in conjunction with its other merits. Full public hearings and debate on changes or new provisions provide an opportunity for Congress to learn of the potential administrative, compliance, and policy concerns of taxpayers. With public exposure, Congress has a better opportunity to craft legislation that will stand the test of time and not need frequent amendment to address technical problems. Hearings also give the public a better understanding of the provision and its purpose, and they increase the overall perception of fairness in the tax system.
It is possible to enact a simpler tax code. However, as history has shown, the difficulty arises in keeping it simple when faced with the constant need to raise revenues, and pressures to use the tax law to implement social and economic policy.
While the judiciary is the focal point for settling controversies between the IRS and taxpayers, Congress plays an important role as well. In cases where factual differences preclude establishing broad principles and rules, Congress must consider the efficacy of establishing objective rules to eliminate the controversies. A recent example was the debate on the amortization of intangibles, which was resolved prospectively with enactment of IRC section 197. While establishing a fixed amortization period of 15 years creates inequities in individual situations, the resulting certainty has in most cases made the law much easier to comply with and administer.
In many situations, Congress will similarly need to weigh competing consequences in making the final decision.
Indicators for Tax Simplification
E. Developing Measurement Instruments
Instruments that aid in evaluating a proposal's contribution to simplification or complexity are necessary to provide a framework for considering tax legislative proposals. Such instruments should provide:
One example of an instrument designed to accomplish these objectives is the Indicators for Tax Simplification, contained in the AICPA Blueprint for Tax Simplification. The indicators consist of considerations indicative of both positive and negative influences on the complexity of the tax system. The ability of a proposal to have as many positive influences as possible and to avoid having as many negative influences as possible should indicate that it will contribute to the simplification of the tax system.
Many proposals needlessly add to the complexity of the tax system solely because their potential effects in this regard were not considered. Use of the indicators encourages such an evaluation to occur. Over time, it can become an integral part of the legislative process. Use of the indicators can identify areas in which the contribution to simplification of any proposal can be enhanced.
The indicators, or a similar framework for the disciplined examination of a proposal's effects on simplification, should be used whenever a proposal is being considered for legislative or regulatory action.
To compare various competing proposals, it may be desirable to weigh the factors included in the indicators for their relative contributions to simplification in the context of any specific proposal. This will allow for the development of a simplification or complexity scale that can be used to rank competing proposals.
Whether or not a complexity scale is used to evaluate competing proposals, the analysis of a proposal's effect on each factor included in the indicators can still be useful. The indicators will demonstrate whether the proposal is assessed negatively for a particular factor. This information will focus attention on possible changes that would minimize the increase in complexity. Where the proposal's effect on a factor is positive, consideration should be given to whether the maximum level of simplification has been attained given the need to meet other objectives.
Another tool for measuring the relative complexity, or simplification, of a proposed tax law change is the AICPA Tax Complexity Index, which is still undergoing refinement. The Index is comprised of 15 relatively objective, multiple choice questions and 5 subjective questions that address issues that must be examined in conjunction with the overall complexity score. The resulting scores for alternative tax proposals should be ranked from negative to positive and viewed as a relative measure of complexity. While the raw scoring of competing proposals can vary among individual evaluators, the Index has been shown to provide reasonable consistent results when comparing the rankings of scores for each evaluator of the proposals from simple to complex.
The Indicators for Tax Simplification and the Tax Complexity Index are examples of tools that addresses only a proposal's contribution to simplification. It may also be desirable to develop tools that will balance simplification with other demands placed upon tax law, such as fairness and the need to raise revenue. Such tools will be useful in determining which simplification proposals are most compatible with other objectives of our tax law.
F. Using the Simplification Measurement Tools
It is not sufficient to develop tools that measure a proposal's effect on the complexity of the law. Procedures must also be put in place to ensure that the tools will be used and that the information obtained will be formally considered. The following procedures are suggested as a means of ensuring consideration of a proposal's impact on tax law complexity.
Hearings Process Procedures - Hearings on tax proposals before either the House Ways and Means or the Senate Finance Committee should require disclosure of the proposalsí effect on simplification. Analysis of such effects by the staffs of both the Joint Committee on Taxation and the Tax Legislative Counsel should be published and discussed. The staff of the Joint Committee on Taxation should be required to adopt a methodology for evaluating the simplification aspects of a proposal and to discuss the results in any hearing pamphlets (or other documents) published. In addition, simplification options with respect to the proposals under consideration at the hearing should be discussed.
Testimony by representatives of the Treasury Department should include an independent analysis of the effect of any proposals on simplification, as well as evaluation of the published comments of the staff of the Joint Committee on Taxation.
Legislative Markup Process - All proposals considered during the legislative markup process should also be evaluated to determine their effect on simplification. If the markup begins with the acceptance of a Chairman's Mark or other basic document, a simplification analysis should be required for each item in the mark. Amendments must include analyses of their effect on simplification before being considered. At each step, the staff should be prepared to offer alternatives to the items included in the mark or offered as amendments that could make greater contributions to simplification.
Legislative Drafting Process - The staffs of the House and Senate Legislative Counsel's Offices should be instructed by the members to undertake a study of drafting techniques that would contribute to simplification, such as horizontal drafting. Candidates for horizontal drafting include the constructive ownership rules and the provisions governing pass-through entities and their owners or beneficiaries. The respective Legislative Counsel's Offices should be required to publish the results of their study within a reasonable period of time.
Regulatory Process - The Treasury Department and IRS should be required to include an analysis of the effect of any proposed, temporary, or final regulations on simplification, along with a discussion of alternative approaches.
Simplification Initiatives - Appropriate governmental staff (Treasury, IRS, Ways and Means, Finance, Legislative Counsel, and/or Joint Committee on Taxation) should be required periodically to publish simplification initiatives that could form the basis of future legislation. Such initiatives could include:
The AICPA has created a Task Force on Restructuring the Internal Revenue Service to provide input to this commission. The task force anticipates submitting additional comments and suggestions in early 1997. Areas on which they are likely to comment include:
A. Privatization of Collection and Processing
Consideration of the privatization of the IRSí collection and processing activities should take into account concerns regarding confidentiality of taxpayer information and correction of errors during the collection process.
B. Need for New Approach to Audit Research
Adaptation of technologies should focus on the better use of existing information reporting and other sources of information.
C. Need for Modernization of Systems
IRS systems need to be modernized to enable it to process information on a timely basis and to perform its collection process in a more efficient, effective manner.
D. Need for Business Approach
The IRS should adopt more of a business-like approach to its operations.
In addition, the AICPA Tax Division will be submitting specific technical recommendations for simplification of unduly complex areas of the law. In 1990, the House Committee on Ways and Means solicited public comment on tax law complexity. The results of that effort were published as Written Proposals on Tax Simplification, dated May 25, 1990. The AICPA Tax Division was the single, largest contributor to that effort. With the renewed interest in examining the complexity of the tax law, the AICPA has again undertaken a major initiative to develop a comprehensive package of tax simplification recommendations to be submitted in early 1997.
One way to demonstrate and emphasize the tremendous, increased complexity of the tax law is through practical examples of areas of law which have grown to be unduly complex for ordinary taxpayers. One can also look to simple comparisons of facts over the years as simple measures of complexity. On balance, there are also examples of where in-roads to simplification have been made which can be used as models for future efforts. For example:
A. Interest and Tracing Rules
Under present law, the deductibility of nonbusiness interest expense is governed by a variety of rules, based on the classification of the debt to which the interest expense relates. While there is policy justification for the disparate treatment of various types of interest expense, some taxpayers encounter significant difficulty allocating interest expense for a single account where funds are used for different types of expenditures. Significant compliance time and expense can be expended to trace small amounts of interest to specific uses. Any effort to simplify the tax law should look to areas which impact a broad category of taxpayers in an adverse manner with minimal revenue implications. Small simplifications in these areas can have a significant impact.
B. Phase Out of Itemized Deductions and Personal Exemptions
If an individualís adjusted gross income exceeds a certain level, otherwise allowable itemized deductions are reduced. Likewise, the personal exemption amount for a taxpayer whose adjusted gross income exceeds a specified threshold is reduced an applicable percentage. The underlying policy goal of these measures is to increase the progressivity of the tax system by having high income taxpayers pay a greater tax burden. However, the same results could be achieved through simpler methods, such as an adjustment to the top of the tax rate schedule. In any redesign of the system, consideration should be given to simpler ways to achieve the desired policy goal.
C. Earned Income Credit
The earned income credit has undergone multiple, significant legislative revisions in recent years. Administering these legislative changes has caused more negative comments about the IRS than generated by most programs it is responsible for administering. In examining restructuring of the IRS, consideration should be given to allowing the Service to focus on its primary mission, like revenue collection, with renewed emphasis on basic services. Consideration should be given to better methods or different agencies for the administration of social and economic policy.
D. Limitation on Meal and Entertainment Deduction
The amount of an otherwise allowable business deduction for meal or entertainment expenses is reduced by 50 percent. This limitation serves the policy goal of raising revenues. However, the use of limitations, phase outs and floors adds considerable complexity to the computation of income and deductions. In designing a simpler tax system, the goal of revenue raising must be balanced against the competing policy goal of simplification. In addition, the economic realities of transactions should be considered.
E. Alternative Minimum Tax
Corporations are subject to alternative minimum tax (AMT), in addition to all other tax liabilities, to the extent that it exceeds the corporationís regular income tax liability. In effect, a corporation must at the least perform dual recordkeeping and prepare two tax returns. In designing a simpler tax system, there should be an examination of the need and desirability of parallel systems of taxation. Does the benefit justify the cost?
F. Health Insurance Premiums
Under present law, the treatment of health insurance premiums for an individual is handled in at least three different ways. If the employer pays the premium then the individual is not taxed on this amount. A self-employed individual will receive a deduction for 30 percent of the premium. Finally, if the individual is not in either of the above situations and itemizes deductions, the premium is deductible as a medical expense, but only to the extent all medical expenses exceed 7 ½ percent of adjusted gross income. Furthermore, the treatment of an S corporation shareholder differs from a C corporation shareholder. There is no "good" policy reason why the type of taxpayer should change the taxability or deductibility of an item. In designing a simpler tax system, there should be examination of ways to consistently treat items of income and deductions. Such a system will be easier to administer and will foster compliance.
G. Forms and Instructions
A simple means of measuring the increased complexity over the years to the tax system is the length of forms and instructions. For example, in 1974 the Form 1040A was a half page front and back with 13 pages of instructions. There were 4 lines for income. The rate schedules and tax tables were 8 pages in length with 2 methods used to calculate the tax. In 1995, the Form 1040A was a full page front and back with 80 pages of instructions. There were 6 lines for income. The rate schedules and tax tables were 6 pages long just utilizing a single method of calculation of tax through tax tables. The increased length of forms and instructions is a very simple measure of the increased complexity of the underlying law. This significant expansion to the length of forms and instructions occurs throughout all areas of reporting.
H. Entity Classification
An area that has created considerable uncertainty and complexity is tax classification of unincorporated business entities. Proposed regulations under section 7701 are an excellent example of simplification which can be accomplished in an unduly complex area of law. The proposed regulations greatly simplify the tax classification area. The Treasury Department and Internal Revenue Service are to be commended for its efforts in this area and encouraged to seek additional areas where similar efforts can be undertaken.
I. Technical Termination of a Partnership
Another way to achieve considerable simplification is through the drafting and design of regulations. An example of this is proposed regulations under section 708. These regulations revise the deemed structure of a technical termination of a partnership that occurs if, within a 12-month period, there is a sale or exchange of 50% or more of the total interest in a partnershipís capital and profits. We commend the Treasury and the IRS for the simplicity achieved through these regulations in a very complex area of law.
The AICPA appreciates the opportunity to offer comments at todayís hearing and looks forward the opportunity to provide additional input into your study.