What are 10 ways to simplify the tax system?
The individual income tax imposes complexity that costs not only taxpayers, who expend time and money preparing and filing their returns, but also the IRS, which is responsible for auditing those returns and dealing with taxpayer errors. Here are 10 things Congress could do to simplify the income tax and reduce costs significantly for both taxpayers and the IRS.
- Modify or repeal the alternative minimum tax: Originally designed to ensure that high-income households paid at least some income tax, the alternative minimum tax (AMT) now affects 4 million filers, most of whom already pay significant amounts of income tax and are far from the top of the income distribution. Congress raised the AMT exemption and indexed both the exemption and other relevant parameters for inflation in 2012, but did not fix the AMT’s basic problems. Modifying the AMT so that it only affects higher-income taxpayers who would otherwise pay little tax would return the tax to its original purpose. But it would hardly 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, but revenue would decrease by roughly $30 billion annually.
- Eliminate or align income limits and phaseouts: Many preferences in the tax code are denied to higher-income taxpayers or phased out over different ranges of income. These inconsistencies complicate tax returns; several worksheets are required to calculate taxable income, deductions, and credits. For example, the tax code reduces the $1,000-per-child credit by 5 percent of adjusted gross income (AGI) over $110,000 for married couples ($75,000 for single parents and $55,000 for married couples filing separately); 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 the deduction for interest paid on student loans phases out for single taxpayers with modified AGI above $65,000 ($130,000 for joint filers). Eliminating such restrictions would simplify tax filing, but the benefits would go to higher-income taxpayers. Retaining income limits on tax preferences but setting them at uniform levels (at least for related activities), would reduce complexity while still focusing benefits on taxpayers with low-to-moderate incomes. Note, however, that if multiple benefits phased out over the same income range, effective marginal taxes in that range could reach unacceptably high rates.
- Consolidate tax benefits for education: 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 American opportunity credit or the lifetime learning credit, but not both, for the same student. If the family supports more than one student, it may claim one credit for one student and the other for the second student. Determining which alternative is best requires multiple calculations and can conflict with other tax benefits for education, such as Coverdell savings accounts and 529 savings plans. Combining or at least coordinating the various tax benefits would help taxpayers both determine their eligibility for benefits and calculate them.
- Coordinate tax benefits for dependent care: Taxpayers may reduce the net cost of 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 both planning how to finance childcare and completing tax returns difficult. 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 recipient’s Social Security benefits are subject to tax depends on income: single beneficiaries with adjusted incomes 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 a 19-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.
- Simplify the taxation of capital gains and dividends: The income tax currently imposes many different tax rates on capital gains and dividends, depending on the taxpayer’s regular tax rate, the type of asset, how long an asset was owned before it was sold, whether dividends are “qualified,” and whether the taxpayer owes AMT. The IRS provides four different worksheets, one with 45 lines, to help taxpayers calculate their tax on capital gains and dividends. Allowing a percentage exclusion for qualified dividends and 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 effective tax rates on different kinds of gains and dividends.
- Combine tax incentives for retirement saving: Workers can currently save for retirement in various ways that receive different tax treatment—among them 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 deciding how best to save for retirement. Combining existing options into fewer alternatives and setting the same income limits for all would simplify workers’ choices and reduce the cost of administering multiple programs.
- Consolidate programs benefiting households with children: Personal exemptions, the child tax credit, and the earned income tax credit (EITC) all provide benefits for households with children. But each imposes different restrictions on participation, offers varying benefit levels, and requires beneficiaries to complete separate parts of tax returns. Combining all three benefits into a single refundable credit would both simplify tax filing and coordinate benefits. It could be difficult, however, to design a simple single credit that would 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 worksheet to calculate the credit itself (though taxpayers may elect to have the IRS complete the second task). That complexity results from strict definitions of which children qualify, 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 parameters the same across taxpayers with different characteristics could reduce complexity. But this would also limit flexibility in adjusting benefits to perceived need.
- Use a single definition of “child”: Various income tax benefits are targeted at families with children. But the definition of “child” differs widely, particularly with respect to age. Children under age 19 (or under 24 and a full-time student) 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 choices about who should receive benefits, they complicate tax filing and can lead to filing errors that the IRS has to correct. Other factors further complicate eligibility determination, 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 simplify both tax filing and IRS processing of returns.
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