Do Lower Tax Compliance Costs Lead to Higher Taxes?

 
 
March 19, 2007

Economists often complain about the costs of a complex tax code. In our own latest estimate, we found U.S. taxpayers bear about a 22-cent surcharge for every dollar of federal income taxes paid, in the form of time and effort spent keeping records and filing tax forms each year. Economists teach that these costs are "deadweight losses" to the economy, representing pure economic waste that doesn't make anyone better off.

However, some have argued that a complex tax code has an unanticipated side benefit—it keeps tax burdens lower that they would otherwise be by making taxes more "painful" to taxpayers. For example, economist Milton Friedman famously regretted his work in helping develop the federal income tax withholding system during WWII, on the grounds that by withdrawing taxes directly from paychecks it made Americans less aware of their federal tax bill and more accepting of tax increases.

So was Friedman right? A terrific new NBER working paper sheds some light on the issue. In it, MIT economist Amy Finkelstein tests the relationship between tax transparency or "salience" and the level of tax burdens by looking at toll booth fees in the Northeast before and after electronic toll collection. Electronic toll collection substantially reduces the compliance costs of tolls, and generally reduces their transparency to drivers.

The result? Here's from the abstract:

This paper tests the hypothesis that the salience of a tax system affects equilibrium tax rates. To do this, I analyze how toll rates change after toll facilities adopt electronic toll collection. Unlike manual toll collection, in which the driver must hand over cash at the toll collection plaza, electronic toll collection automatically debits the toll amount as the car drives through the toll plaza, thereby plausibly decreasing the salience of the toll. I find robust evidence that toll rates increase following the adoption of electronic toll collection. My estimates suggest that, in steady state, toll rates are 20 to 40 percent higher than they would have been without electronic toll collection.

Read the full piece here. For more on our work on tax compliance costs—which, despite Finkelstein's excellent scholarship, most of us would still like to see reduced through tax simplification whenever possible—see our "Compliance Costs and Tax Complexity" section.

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