Optimum Tax Compliance Costs and Tax Simplification

1. Optimum Tax Compliance Costs and Tax Simplification Simon James and Alison Edwards Australian School of Taxation University of New South Wales, Sydney 4 May 2007 ESRC funding is gratefully acknowledged

2. 1 Introduction • Optimum level of compliance costs is not zero. • The simplest tax system is not necessarily the best tax system. • Trade-offs between different aspects of the tax system important in both tax research and tax policy.

3. Compliance costs • For example – Sandford et al. minimizing operating costs incurred in obtaining a given revenue for a given tax structure. • But many other considerations e.g. • Purpose of the tax – perhaps to reduce consumption of alcohol, tobacco, fatty foods even. Better to have high compliance costs?

4. Wider approach – consider: • Aims and objectives of the tax system. • Wider economic and social context. • Efficiency, equity, macroeconomic aspects. • Administrative and other constraints.

5. Question • How far should researchers take account of the wider context? • Limited knowledge? • Rational to consider one part at a time? • In-depth knowledge requires scope of research to be limited? But: • Failure to do so might lead to the wrong conclusions.

6. General Theory of the Second Best • It is not true that a situation in which more, but not all, of the optimum conditions are fulfilled is necessarily, or is even likely to be, superior to a situation in which fewer are fulfilled – Lipsey and Lancaster (1956). • Their tax example – tax one good and the implications for optimality with respect to taxes on other goods could vary widely.

7. Just too difficult? • The fundamental problem is that, as with all second-best arguments, determination of the conditions under which a second-best policy actually leads to an improvement of social welfare requires detailed theoretical and empirical investigation by a first-best economist. Unfortunately, policy is generally formulated by fourth-best economists and administered by third-best economists; it is therefore very unlikely that a second-best welfare optimum will result from policies based on second-best arguments (Johnson, 1970).

8. Implication of the second best • The failure to consider a much wider range of factors than is currently the norm might mean that an ‘improvement’ in tax compliance or simplification does not lead to an overall improvement at all. When the wider context is included, the overall disadvantages may be greater than the more obvious benefits of the initial change.

9. Optimal Taxation • Attempts to take account of both economic efficiency and equity. • Provides many interesting insights but has not been able to incorporate all the ‘incredible complexity’ that must be considered in the design and reform of tax systems.

10. Reinforces the Point • Optimal taxation approach reinforces the point that it is a difficult and complex process to develop changes to the tax system where the advantages outweigh the disadvantages. But: • Giving the wider context less attention than it deserves is not the way to proceed.

11. 3. Compliance • Understandable, perhaps essential, that research concentrates on a particular aspect. • But can undermine the conclusions. • Often at least imply that compliance costs should be minimised. • Often imply that they should not be regressive.

12. Current investigation • Does the research ignore other factors? • Does it acknowledge other factors could affect the conclusions? • Are other factors taken into account seriously? • Which factors are taken into account?

13. 4 Tax Simplification • Academic glass house: IFS • ‘While the literature on nonclassical measurement error traditionally relies on the availability of an auxiliary dataset containing correctly measured observations, this paper establishes that the availability of instruments enables the identification of a large class of nonclassical nonlinear errors-in-variables models with continuously distributed variables’.

14. Approach to Simplification often Simplistic • Calls for simplification often very narrow • Often assumes complexity in taxation exists in isolation but may reflect wider trends. • Often assumes taxpayers want simplification when they might not. • Often important reasons for complexity • Need to define simplification • Need to take into account the wider context

15. 165-55 A New Tax System (Goods and Services Tax) Act 1999 • For the purpose of making a declaration under this Subdivision, the Commissioner may: • a) treat a particular event that actually happened as not having happened; and b) treat a particular event that did not actually happen as having happened and, if appropriate, treat the event as: • i) having happened at a particular time; and ii) having involved particular action by a particular entity; and • c) treat a particular event that actually happened as: • i) having happened at a time different from the time it actually happened; or ii) having involved particular action by a particular entity (whether or not the • event actually involved any action by that entity).

16. Pages of Primary Federal Tax Legislation • India 9,000 • UK 8,300 • Australia 7,750 • Japan 7,200 • USA 5,100 • Source: PriceWaterhouseCoopers

17. Also Secondary Legislation • Regulations • Revenue authority interpretations • Formal tax rulings • Case law

18. Tax Law Reviews • UK Tax Law Review Committee, 1994 • Australia TLIP. • Some undoubted improvements but: • E.g. ‘Your assessable income includes income according to ordinary concepts, which is called ordinary income.’ • Does not deal with underlying complexity.

19. Not a New Problem- • When Mr Lloyd George was Chancellor of the Exchequer the Board [of Inland Revenue] had occasion to send him a paper expounding the technicalities of the estate duty charge on settled property; Mr Lloyd George rejected this paper and demanded an explanation in words of one syllable. The Board sent a new paper – in words of one syllable; but the subject matter remained as complicated as before and the monosyllables made it rather harder to understand (Johnson, 1965).

20. Taxes Reflect Wider Trends • Ross Clark – How to label a goat - Sheep and Goats (Records, Identification and Movement) (Wales) Order 2006 - 45 densely written pages regulating ear tags on Welsh sheep and goats. • In the year to 31 May 2006 the UK Government passed 3,621 pieces of legislation, possibly 72,400 pages of it and 26,200 of explanatory notes.

21. Disadvantages of Complexity • Compliance and administrative costs. • May discourage economic activity. • Reduce taxpayers’ willingness to comply. • Uncertainty in making economic decisions. • Can generate unfairness. • Makes tax reform more difficult

22. Do Taxpayers want Simplification? • Very - when there is little or no cost to achieving it. There is often much to be gained. • However, plenty of examples to demonstrate it is not always top priority e.g. the community charge or poll tax • Many want simplification in general and complexity in particular (their cases).

23. Reasons for Complexity • Fairness between taxpayers. • Tax used for non-revenue purposes: • Tax expenditures • Corrective taxation. • Increasingly complex environment. • Nature of tax reform. • Legal language.

24. Applying Law to Economic Life • For example – income, four questions: • Is it income? • Whose income is it? • What kind of income is it? • When is it income? • All lead to complexity in law and administrative rulings.

25. Legislation is not Literature • [The] sentence is constructed with that mathematical arrangement of words which lawyers adopt to make their meaning unambiguous. Worked out as one would work out an equation, the sentence serves its purpose; as literature it is balderdash. • - Sir Ernest Gowers, Complete Plain Words

26. Complexity has Advantages • For example, in recent years the Australian Tax Office has put its legal data base on its web site. This includes an enormous amount of material and, in the past, would often have been too difficult to access for most purposes. However, the search engines now allow guidance to be found quickly on the most obscure issues. Advances in technology have made what was once very complex now very simple to use.

27. What is Simplification?Cooper suggests at least 7 Issues • Predictability – A rule is easily and accurately understood. • Proportionality – the complexity of the rule is no more than needed to achieve its aim. • Consistency – rule deals with similar issues in the same way.

28. Continued.. • Compliance – the rule is easy and cheap to comply with. • Administration – easy to administer. • Co-ordination – rule fits with other rules. • Expression – the rule is simple if it is clearly expressed.

29. Simplification at Different levels • The choice of the tax base. • The design of the rules applied to that tax base. • The expression of those rules. • Administrative requirements imposed on taxpayers.

30. Simplification at One Level • Can work even with a complex system e.g. • UK cumulative PAYE system means most taxpayers are not required to complete an annual return. • US 1040EZ • ‘Pre-populated returns’ • Improve communications with taxpayers • Improve taxpayer assistance

31. Small Businesses • Very important part of the economy. • May lack expertise and other resources to cope with complexity. However: special provisions may be possible e.g. • Simplified tax reporting requirements for small businesses.

32. Strategy for Simplification • Evaluate the importance of different aims of tax policy. • Incorporate simplification into the tax policy process itself. • Develop a ‘simplification culture’. • Monitor and review progress.

33. Improvements to Tax Reform • Compliance and simplification should be part of general considerations in tax policy to allow trade-offs between simplicity and other goals. • Tax reform generally should be improved • Preference for a permanent body to evaluate tax reform

34. Conclusion • Need to consider the wider context. A policy to minimize compliance costs or to simplify the tax system without sufficient regard to other matters may not improve matters overall. For example, the work on simplifying tax law does not seem to have achieved a great deal in terms of tax simplification and is unlikely to do so unless it takes account of the subject as a whole

35. Comments Very Welcome