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What's Wrong With Our Taxes, and How to Fix Them

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Taxpayer Advocate Nina Olson -- our collective friend and ally inside the Internal Revenue Service -- has just released her latest report. If only Congress would act on it!

This year, Olson's top issue is our urgent need for tax reform. As she notes, people have been clamoring for this for years, but little real progress has been made. Right now, both the Obama administration and Republicans are calling for reforms and considering lowering the corporate tax rate among other changes.

Olson offers a few examples of what's working well. "About 97% of all tax revenues the IRS collects come in without the need for direct enforcement actions -- because of voluntary compliance," she notes. According to Olson, most Americans have benefited from some huge tax breaks, such as the deductibility of mortgage interest and the exclusion from income of retirement-plan contributions. Even the employer exclusion of health-insurance costs helps taxpayers, by encouraging employers to offer that insurance in the first place.

Big numbers
But Olson focuses more on what really isn't working well.

She estimates that the tax code now contains 3.8 million words, which would fill 11,045 single-spaced pages. It undergoes hundreds of changes each year -- including nearly 600 in 2010 alone. All this leaves the average taxpayer ill-equipped to prepare a tax return correctly. Baffled citizens place more than 100 million calls to the IRS each year; as many as 25% of them go unanswered. Worse, a 2004 Treasury Department study found that the IRS gave incorrect answers 20% of the time -- which is kind of understandable, given the complexity of the tax code.

Indeed, that complexity inevitably leads many people to make honest mistakes, which either shortchange the government or the taxpayer. For example, in 2006, most taxpayers could claim a one-time tax credit of $30 to $60, related to telephone excise taxes that had been unfairly collected in the past. Yet 28% of eligible taxpayers (37 million people) didn't claim this free money, presumably because they didn't know about it.

Thus, as Olson notes, a whopping 60% of taxpayers pay a preparer to do the work, while 29% use tax-prep software packages. Just 11% go it alone. Tax preparation costs the typical taxpayer about $258 annually.

All that has helped build a huge tax-preparation industry. It takes individuals and businesses 6.1 billion hours to comply with tax requirements, which Olson estimates amounts to the equivalent of more than 3 million full-time workers. That's more than the federal government's 2 million civilian workers and the U.S. Postal Service's 600,000 career employees, combined. Heck, it's more than the total employee base of Wal-Mart, IBM, and UPS put together!

Perception problems
Olson also explains another unpleasant result of the complex tax code: negative perceptions, cynicism, and lower compliance. We all know that the code is full of special tax breaks, and we resent the notion that others are getting benefits denied to us. The "Railroad Track Maintenance Credit," for example, "provides a special credit for taxpayers who happen to own a railroad."

Such thinking fuels lower compliance rates among those who self-report their income, and thus shortchanges the government on tax revenue. (It also fosters more resentment from those who those who don't self-report, and thus can't get away with the same tricks.)

Olson offers many recommendations to fix these problems.

Just as we at The Motley Fool have long applauded clear communications from CEOs to shareholders, Olson calls for more clarity from the IRS to taxpayers, particularly regarding where our tax dollars go. She suggests a kind of receipt showing just what we're buying with our federal taxes, and quotes a commenter:

Sending taxpayers a one-page summary of Federal spending is a big step toward a more rational discussion of debt and deficits. Polls show Americans think over 50% of the Federal budget is wasted; liberals think it all goes to wars, conservatives think it all goes to welfare and foreign aid. If people knew that half the budget goes to Social Security, Medicare, Medicaid and interest on the debt, everyone would recognize the need for tough choices on taxes and spending.

To overhaul the code, she suggests eliminating most tax breaks (even ones people love, such as mortgage interest deductions), and instituting much lower tax rates that would leave us paying the same amount. With the average taxpayer saving about $8,000 in taxes due to current breaks, the effective tax rate paid drops from 25% to 9%. Olson imagines a scenario where the breaks are gone, and that taxpayer just faces a 9% tax rate. We'd gain simplicity, and the government wouldn't be any worse off financially. Greater transparency would lead to greater trust in the system, since we'd be able to see it treating people fairly.

It's depressing to think about all the problems in our tax code, but solutions abound. Add your own ideas via the Taxpayer Advocate's new Suggestion Box.

We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Longtime Fool contributor Selena Maranjian owns shares of Wal-Mart, which is a Motley Fool Inside Value recommendation and a Motley Fool Global Gains pick. UPS is a Motley Fool Income Investor selection. The Fool owns shares of IBM, UPS, and Wal-Mart. Try any of our investing newsletter services free for 30 days. The Motley Fool is Fools writing for Fools.

Read/Post Comments (4) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 10, 2011, at 7:20 PM, ChrisBern wrote:

    She sounds like a great advocate to have on "our" side in the IRS!! Kudos.

    As far as seeing what the federal government spends its money on, "If people knew that half the budget goes to Social Security, Medicare, Medicaid and interest on the debt...", that wouldn't make me feel one bit better. I guess if you love the Great Society it might make you feel better. Besides, what's the OTHER half go to?? :)

  • Report this Comment On January 11, 2011, at 1:39 AM, dgmennie wrote:

    Of course taxes are too high on most wage slaves. It is not just the Federal bite, its state income taxes, sales taxes, and (for many) local property taxes. Add all this stuff up and your income is mostly gone propping up our multi-layered Government structure.

    Most of the specal tax breaks on the books (despite the recent dust-up about eliminating the mortgage interest deduction) actually go to big corporations and a tiny number of the very rich who can influence these things and create loopholes for themselves. All the expensive, do-good Government agencies have failed to keep these guys from sending jobs overseas, corrupting the banking system, and destroying local environments. Meanwhile, endless US involvement in foreign wars helps many others who profit from military contracts for everything from high-tech weapons to toilet paper.

    Momentum for genuine tax reform is going to literally mean replacement of the Government (on all levels) as we currently know it. Who is prepared for that? And who can offer any genuine, lasting improvements that most of us can enjoy after the dust of revolution settles?

    Lets face it: public employees of all stripes will fight real tax reform with their dying breath. And there are millions and millions of them who vote and are reasonably well organized. Those proposing change (Nina Olson included) are still yelling into the wind and trying to hold back the tide with a sponge.

  • Report this Comment On January 11, 2011, at 6:18 PM, gdett2 wrote:

    I would like to see a much simpler tax code.

    The amount of time wasted doing complex ministrations just makes citizens more and more angry with the government in general.

    IMHO, 90+ percent of the taxpayers would be much happier with a simplified tax code.


  • Report this Comment On January 19, 2011, at 7:18 PM, n8larson wrote:

    I see all those benefits, but the second to last sentence has a problem... "the government wouldn't be any worse off financially" is all well and good, but the government wouldn't be any BETTER off financially, either. It's time to pay the piper before the debt hole gets any worse. I know we're not as badly off as a few nearly-insolvent European governments, but we've been borrowing from our children for too long by continuing to lower taxes. Simplified is great, to be sure, but we're not going to simply grow out of our $14 Trillion debt. Only a prolonged surplus will reduce that debt, and a combination of restored taxes and serious spending cuts is the way to achieve it.

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