Incremental Reform: What are ten ways to simplify the tax system?
The complicated nature of the individual income tax imposes costs not only on taxpayers, who expend time and money preparing and filing their returns, but also on the Internal Revenue Service, which has to audit those returns and deal with the inevitable mistakes taxpayers make. Various steps to simplify the income tax could reduce costs significantly for both taxpayers and the IRS.
- Modify or repeal the alternative minimum tax: Originally designed to ensure that high-income taxpayers pay at least some income tax, the alternative minimum tax (AMT) now affects 4 million households, most of whom already pay significant amounts of income tax and are far from the top of the income distribution. Only annual congressional "patches" to the AMT have kept it from affecting millions more taxpayers. Modifying the AMT to permanently limit its reach would maintain some of its revenue stream while protecting most taxpayers from the tax, but would not make the tax system simpler for those still subject to it. Repealing the AMT would both simplify the income tax and eliminate the need for annual patches.
- Eliminate or align income limits and phase-outs: Many features of the tax code are denied to some higher-income taxpayers or phase out over different ranges of income. These features complicate tax returns and require multiple worksheets to calculate taxable income, deductions, and credits. For example, the tax code reduces the $1,000-per-child tax credit by 5 percent of adjusted gross income (AGI) over $110,000 for married couples ($75,000 for single parents); the share of expenses allowed for the child and dependent care credit falls from 35 percent to 20 percent as AGI increases from $15,000 to $43,000; and single taxpayers with AGI above $55,000 ($110,000 for joint filers) may not deduct the interest they pay on student loans. Eliminating such restrictions would simplify tax filing, but the benefits would go to higher-income taxpayers. Retaining these income limits but setting them at the same or similar levels, at least for related activities, would reduce complexity while keeping the benefits aimed at taxpayers with low to moderate incomes. At the same time, however, if multiple benefits phased out over the same income range, effective marginal tax rates in that range could reach unacceptable levels.
- Combine education tax benefits: Families with students in college may qualify for multiple tax benefits to defray educational expenses but often may claim only one of them. For example, a family may be able to claim either the HOPE credit or the lifetime learning credit, but not both for the same student; if the family has more than one student, it may claim one credit for one student and the other for a second student. Determining which alternative is best requires multiple calculations and can conflict with the use of other tax benefits for education, such as Coverdell savings accounts and 529 savings plans. Combining or at least coordinating the various tax benefits would make it easier for taxpayers both to determine their eligibility for benefits and to calculate them.
- Coordinate tax benefits for dependent care: Taxpayers may reduce their costs for dependent care through the child and dependent care credit and through flexible spending accounts set up by their employers. They may, however, use only one of the two options for a specific expense, which can make it difficult both to plan how to finance child care and to complete tax returns. Coordinating the two benefits or combining them into a single benefit would address both problems.
- Simplify or eliminate the taxation of Social Security benefits: Whether and how much of a person’s Social Security benefits are subject to income tax depends on the person’s income: single beneficiaries with adjusted income below $25,000 ($32,000 for couples) pay no tax on their benefits; those with higher incomes must include up to 85 percent of their Social Security payments in taxable income. Determining the amount to include requires completing an eighteen-line worksheet that draws on information from other parts of the tax return. Making a fixed fraction of benefits taxable (possibly zero) for all beneficiaries would eliminate that worksheet and make tax filing easier for them.
- Simplify the taxation of capital gains: The income tax currently imposes at least eight different effective tax rates on capital gains, depending on the taxpayer’s regular tax rate, how long an asset was owned, the type of asset, and whether the taxpayer owes AMT. The IRS provides three different worksheets, one with 37 lines, to help taxpayers calculate their tax on capital gains. Allowing a percentage exclusion for long-term gains (and perhaps other kinds of gain) and applying regular tax rates to the rest would sharply reduce the complexity of returns while maintaining different treatment for different kinds of gain.
- Combine tax incentives to save for retirement: Workers can currently save for retirement in various ways that receive different tax treatment; these include deductible, nondeductible, and Roth Individual Retirement Accounts, regular and Roth 401(k)s and similar plans, and traditional employment-based pension plans. Each type of saving has its own eligibility requirements, income limits, and tax benefits, which complicates the task of choosing among them. Combining existing options into fewer alternatives and setting the same income limits for all would simplify workers’ choices and reduce the cost of administering so many programs.
- Consolidate programs benefiting households with children: Personal exemptions, the child tax credit, and the earned income tax credit (EITC) all provide tax benefits for households with children but impose different restrictions on participation, have varying benefit levels, and require completing separate parts of tax returns. Combining all three benefits into a single refundable credit would both simplify tax filing and coordinate benefits. Doing so might, however, require complex benefit calculations to approximate current benefits.
- Simplify the earned income tax credit: Claiming the EITC currently requires completing a three-page worksheet to determine eligibility, and then a second three-page worksheet to calculate the credit itself (but taxpayers may elect to have the IRS do the second task). That complexity results from strict definitions of qualifying children, different credit rates and income limits depending on the number of children, and different accounting for different kinds of income. Relaxing the requirements and making the credit parameters the same across taxpayers with different characteristics could reduce complexity but would also limit flexibility in providing different levels of benefits.
- Use a single definition of "child": Various income tax benefits go to families with children, but the definition of a "child" differs widely, particularly with respect to age. Children under age 19 count in defining EITC benefits, those under 17 qualify for the child credit, and only those under 13 are eligible for the child and dependent care credit. Although these differences may result from deliberate congressional decisions about who should receive tax benefits, they complicate tax filing and can lead to inadvertent errors that the IRS then has to correct. Other factors used to define qualifying children further complicate the situation, including the child’s physical residence, custody arrangements, and who pays the child’s living costs. Establishing a single definition to determine whether taxpayers may claim tax benefits for children would simply both tax filing and IRS processing of returns.