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Return-Free Filing: What is it and how would it work?

In a return-free tax system, revenue is collected through some combination of withholding and end-of-year reconciliation by the tax agency; individual taxpayers do not file annual returns. In an exact withholding system, the tax agency makes every effort to withhold the exact amount of taxes due from paychecks and other income, so that no end-of-year filing, payment, or refund is needed. In a tax agency reconciliation system, withholding occurs as under the present U.S. system, but taxpayers may elect to have the tax agency prepare their return and thus avoid the burden of tax filing.

  • In a tax agency reconciliation system, tax filing occurs in four steps. Taxpayers electing the option provide certain basic information to the tax authority. The tax authority then calculates their tax liability from this information and from information returns it receives from employers, financial institutions, and other payers. The taxpayer then has a chance to review (and contest) these calculations. Finally, the agency issues a refund or the taxpayer sends a payment.
  • In exact withholding systems taxpayers must report certain minimal, nonfinancial information to either their employer or the tax authority. In a U.S. system this would likely consist of the taxpayer’s name, address, Social Security number, filing status, and the names and Social Security numbers of any spouse and dependents. The employer or the tax authority uses this information to calculate withholding allowances. Taxpayers may be required to report this information on a regular basis or whenever there is a change in their circumstances.
  • Two types of exact withholding systems exist. Cumulative systems (used in the United Kingdom and the Russian Federation) aim to withhold exactly the right amount of tax at each point throughout the year; final withholding systems (used in Germany and Japan) make adjustments to the final paycheck in the tax year to achieve exact withholding. Some countries combine one of these approaches with other requirements.
  • A return-free system in the United States could include a larger number of taxpayers, and would be more effective, if the tax code were adjusted in several important ways: by having the vast majority of taxpayers face the same marginal ("basic") tax rate; by making the unit of taxation the individual rather than the family; by taxing interest and dividend income at a flat rate and withholding it at the source; by largely exempting capital gains from taxation; and by limiting the number of deductions. None of these conditions, however, is necessary for the operation of a return-free system for at least some taxpayers.
  • Neither an exact withholding nor a tax agency reconciliation system provides an easy way to handle capital gains, itemized deductions, business income, employee business expenses, moving expenses, or Individual Retirement Accounts, although some accommodation is possible. A key issue in either system is who bears responsibility for mistakes on the return prepared by the tax authority, and for mistakes in exact withholding made by either the tax authority or the employer or other payer. One major difference between the systems is in where the burden of tax preparation is placed: the tax authority bears much of the additional burden in a tax agency reconciliation system, whereas the burden is largely on employers and other payers in an exact withholding system.
 
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