Howls about the U.S. tax code’s complexity peak at this time of year, when Americans struggle with laws so gnarly that some filers have to tackle six pages of questions to see if a person they support is their dependent.
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No wonder a lot of taxpayers want to blow up the current system. In comment after comment on Tax Report columns, for example, Journal readers call for a flat tax as the answer to the tax code’s confusing complications.
The trouble is, hard problems seldom have easy answers. And U.S. income-tax complexity isn’t just a hard problem, it’s a mind-boggling one with no silver bullet.
There are many reasons for this. The tax code reflects the intricacies of modern financial and social life, and it’s also a mishmash of competing policy interests that shift over time and often interact in unexpected ways.
Another impediment to simplification is human nature.
What one filer or industry sees as a well-deserved tax incentive advancing the public good—such as the mortgage-interest deduction or a tax credit for electric cars—often seems a stupid or wasteful tax break to others. The rock-bottom reality is that no matter how much taxpayers decry tax complexity, few object to it when they benefit.
Yearning for change
Despite such problems, some in Washington are gearing up for a run at radical income-tax simplification. They see an opportunity in the expiration of 2017 tax-overhaul’s changes at the end of 2025. The deadline will mean the end of key income-tax provisions, including current rates and brackets, unless Congress re-ups them.
But taxpayers yearning for simplicity should be careful what they wish for, no matter which party is driving the political bus.
To see why, consider two current proposals from Washington policy groups. One proposal is from the conservative-leaning Tax Foundation. Another is from William Gale, the co-director of the liberal-leaning Tax Policy Center and has a quartet of options that can be mixed and matched. Although these proposals have major differences, especially on redistributing the overall tax burden, they both take aim at longstanding breaks used by millions of taxpayers.
Both would eliminate itemized deductions on Schedule A. So tax breaks for mortgage interest, charitable donations, state and local taxes, medical expenses, and gambling losses, among others, would go. Tax credits for college education and electric vehicles would also go, as would the head-of-household filing status. And more.
As a result, either plan would involve unwelcome trade-offs. For many, the price of simplification could be surprisingly high.
The flat-tax trap
There are other obstacles to tax simplification. Take a flat tax, which seems the simplest of solutions by creating one rate for all. But this gets at only part of the problem.
Income would still need to be defined, and tax definitions typically add far more complexity than tax rates. The mind-numbing language is hard to simplify because it must precisely describe human and economic activities in terms that don’t leave room for loopholes.
That’s why it can take up to six pages of questions to figure out who counts as a dependent. In that way, tax language reflects the complex nature of family life as it tries to prevent double-dipping on benefits for one dependent.
Key to the budget
Meanwhile, there’s tremendous pressure on the individual income tax to raise money for Uncle Sam. In 2022, it provided over half of federal revenues, while other levies contributed far less, according to estimates by the staff of the Joint Committee on Taxation.
In addition, about 80% of individual income taxes were paid by about 10% of filers with income of $200,000 and above. Filers reporting less than $50,000 of income had negative income-tax rates because Congress has chosen to route key benefits for this group through the tax code. These filers do owe Social Security and Medicare taxes, however.
Bitter partisanship in Congress will also make simplification hard. Simplicity advocates typically aim to broaden the income-tax base by eliminating targeted tax breaks and lowering rates—but that provokes a storm of opposition from those affected.
No easy outs
Even when the politicians manage to compromise, the process can take a toll on simplification.
In the Secure Acts of 2019 and 2022, lawmakers struck a bipartisan deal to change retirement-saving rules. But the provisions affecting some inherited accounts were so poorly drafted and confusing that the IRS had to suspend required withdrawals for some heirs for 2021, 2022 and 2023 while it figured out what the law meant.
Investors should note that in any radical tax simplification, a sticking point will likely be the top rate on long-term capital gains, which is currently lower than the top rate on ordinary income.
That’s because the majority of this rate’s benefits go to very wealthy individuals.
In 2023, for example, filers with $1 million or more of income reported 72% of total long-term gains while filers with income between $200,000 and $500,000 reported 12% of them, according to estimates by the Joint Tax Committee staff. If simplification efforts don’t include changes to capital-gains preferences, the wealthy could benefit disproportionately.
Here the past could be prologue: The grand compromise of the historic 1986 tax overhaul was to raise the rate on long-term gains from 20% to 28%. This was the same as the top rate on ordinary income like wages.
The deal didn’t stick, however. The 28% top rate on income was raised within a few years. Then the 28% rate on long-term gains dropped back to 20% in 1997.
The bottom line: The U.S. income tax is like a Gordian knot, except that it can’t simply be cut. It will have to be untangled.
Write to Laura Saunders at Laura.Saunders@wsj.com
