Title 26 of the United States Code (26 U.S.C.), also known as the Internal Revenue Code, is the section of the law of the land dealing with the subject of taxes. In total, the Internal Revenue Code consists of 102 different chapters, organized in nine over-arching subtitles. However, it is measured — by words or by pages — Title 26 is voluminous. The Taxpayer Advocate Service (TAS), an independent organization within the Internal Revenue Service (IRS), estimated in 2010 that the full tax code contained 3.8 million words: enough words to cover over eleven thousand single spaced pages.

Given its prolixity, one would have expected every loophole to be covered and all possible sources of income imaginable taxed. Apparently not. Rather, Title 26 contains broad and narrow exemptions in addition to a range of different income classes, each subject to their own broad and narrow set of rules. The result is a complex and bewildering set of regulations which defy any one individual's ability to master the whole. We doubt Congress could have achieved the same result if it had so intended.

 

 

In 2009, the IRS reported 140.5 Million personal income tax returns were filed. From this starting point, 36.3 Million returns (or, one quarter of the total) are lost to the tax base because of losses, exclusions or deductions. By line 43, taxable income, only 104.2 Million returns survive. In aggregate dollar amounts, total income from all sources falls from $7.7 Trillion to $5.1 Trillion — a decline of more than one-third. This latter amount is what truly constitutes the tax base, since it is the income ultimately subjected to tax.

In the aggregate, $5.1 Trillion generates almost $1.0 Trillion in personal income taxes. But this is not the amount actually due, much less paid. A clutch of tax credits reduces the liability by $88.1 Billion. When all deductions, exclusions and credits are deducted, the federal government's take (in 2009) was $865.3 Billion. As a percent of total income reported from all sources, the IRS collects just a bit more than 11 cents on each dollar.

For a tax regime of byzantine complexity and through-the-looking glass logic, this is a paltry take. When compliance and preparation costs are factored in, the present rules border on satirical. Taxpayers brave enough to prepare their own returns risk enforcement actions for what are probably honest mistakes. Their other choice is to pay for professional assistance. Even then, there is no guarantee the preparer will also not make an unintended error. In its 2010 report to Congress, the TAS estimated that 60 percent of individuals paid for their return's preparation; a further 29 percent purchased software to facilitate preparation. Both are not without cost. In 2007, TAS estimated individual filers spent a median $258 on professional services, software, or other aides to get through tax season.

What are the options? The simplest is broadening the tax base by reducing the tax code's complexity. Yes, this will require shared sacrifice. To build a broad consensus for tax simplification, all must start from the premise that no exclusion, no credit, or no deduction is sacrosanct. Whether deductions for home mortgage interest, health savings accounts or education credits, all must be fair game for tax reform. The goal should be fewer and lower marginal tax rates; especially when less than 60 percent of returns filed in 2009 resulted in any tax liability.

Many will object this smacks of a flat tax. Indeed it does. History demonstrates revenue generation improves the simpler, the fairer a tax is perceived to be. The states offer a guide for reform. While seven taxes levy no personal income tax, 26 of the states that do either have a flat tax or a compact tax rate structure, with the top rate kicking in at comparatively low income levels. We hear no critics descrying these as regressive or unfair. Perhaps Washington should look to the states for inspiration.

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About American Independence Financial Services, LLC

American Independence Financial Services, LLC ("AIFS") is the investment adviser and administrator for the American Independence Funds and the NestEgg Target Date Funds. The firm is a limited liability company founded in 2004.

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