Is Tax Complexity a Market Failure?

January 13, 2006

This week National Taxpayer Advocate Nina E. Olson made the oft-repeated call for fundamental tax simplification in her 2005 report to Congress. From the release

“Our tax code has grown so complex that it creates opportunities for taxpayers to make inadvertent mistakes as well as to game the system,” Olson writes. “As taxpayers become confused and make mistakes, or deliberately ‘push the envelope,’ the IRS understandably responds with increased enforcement actions. The exploitation of ‘loopholes’ leads to calls for new legislation to crack down on abuses, which in turn makes the tax law more complex. Thus begins an endless cycle – complexity drives inadvertent error and fraud, which drive increased enforcement or new legislation, which drives additional complexity. In short, complexity begets more complexity. This cycle can only be broken by true tax simplification, followed by ongoing legislative and administrative discipline to avoid ‘complexity creep.’”

While policymakers universally agree the tax system should be simple, in reality it never is. While lawmakers across the political spectrum denounce the labyrinthine complexity of the federal income tax, its complexity steadily rises.

The reason, of course, is that simplicity has no political constituency. Given the choice between a concrete targeted tax credit vs. the abstract benefits of simplicity, taxpayers will prefer credits every time. And so will lawmakers rewarded for distributing them. And so will tax practitioners rewarded for navigating them. And so will tax administrators rewarded with larger agency budgets for administering them.

After all, simplicity in the tax code is what economists call a "public good." And since economic markets often fail to produce public goods, we shouldn't be surprised when political markets fail as well.

When markets fail to produce public goods, the solution is often government intervention. But what's the solution when political markets fail?

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