Binyamin Applebaum of The New York Times recently authored an op-ed calling for the adoption of return-free filing. Under return-free filing, many taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. payers would receive an already-completed return that they could amend. It’s an appealing idea, but for it to deliver its promised benefits, the U.S. tax code would have to be much simpler.
The potential benefits of return-free filing are well-established. In 2006, future Council of Economic Advisers chairman Austan Goolsbee found that the adoption of return-free filing would save taxpayers $2 billion a year in tax preparation fees, as well as 225 million hours of saved time. When calculating the opportunity cost, he estimated that return-free filing would reduce tax compliance costs by $44 billion over a decade. When factoring in population and economic growth, along with inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spending power. and the rising cost of tax preparation fees since 2005, those numbers are probably much higher today.
At least thirty-six other countries have some version of a return-free filing system. There are two main approaches: exact withholdingWithholding is the income an employer takes out of an employee’s paycheck and remits to the federal, state, and/or local government. It is calculated based on the amount of income earned, the taxpayer’s filing status, the number of allowances claimed, and any additional amount of the employee requests. and tax agency reconciliation. Under exact withholding, employers typically withhold as close to the exact value of taxes owed as possible. Meanwhile, under tax agency reconciliation, the tax administration sends a tentative return to the taxpayer, based on information from third parties, such as employers and financial institutions, which the taxpayer then verifies.
Ultimately, a return-free filing system is only as good as the tax code it’s administrating. As a Treasury Department report noted in 2003, without a series of simplifying reforms, return-free filing would mostly end up shifting the compliance burden from individuals to employers, financial institutions, and the IRS, rather than actually reducing it. The U.S. tax code has changed significantly since 2003—in some ways towards simplicity and compatibility with a return-free filing system as the use of itemized deductions has declined, particularly after the Tax Cuts and Jobs Act of 2017. But in other regards, policymakers have become even more reliant on the tax code as a tool for non-revenue-related public policy goals.
Here are a few problems with the United States tax code that make return-free filing less feasible than it would be in other countries.
- Administering Social Programs Through the Tax Code. Programs like the Earned Income Tax Credit (EITC)The Earned Income Tax Credit (EITC) is a refundable tax credit targeted at low-income working families. The credit offsets tax liability, the total amount of tax debt owed by an individual, corporation, or other entity to a taxing authority like the Internal Revenue Service (IRS), and can even generate a refund, with earned income credit amounts calculated on the basis of income and number of children. and Child Tax Credit (CTC)The federal child tax credit (CTC) is a partially refundable credit that allows low- and moderate-income families to reduce their tax liability dollar-for-dollar by up to ,000 for each qualifying child. The credit phases out depending on the modified adjusted gross income amounts for single filers or joint filers. are major parts of the American social safety net. The United States is more reliant on its tax code to deliver social welfare programs than most European countries with return-free filing. The two credits also have complicated eligibility rules and conditions, which a taxpayer’s employer might not know.
- Household filing. Many of the countries that have done return-free filing do not tax households as a combined unit—instead they tax individuals separately. As a result, administrators do not need to keep track of spousal income as well as employee income. Perhaps eliminating joint filing would be desirable, but it may better approximate a household’s ability to pay taxes.
- Non-Wage Income. Most return-free filing systems are focused on wage income. Interest, dividends, and capital gains are often either fully excluded from taxation or subject to a single, often reduced, tax rate. In the U.S., we classify some capital income (such as short-term capital gains) as ordinary income, and subject it to the same set of seven tax bracketA tax bracket is the range of incomes taxed at given rates, which typically differ depending on filing status. In a progressive individual or corporate income tax system, rates rise as income increases. There are seven federal individual income tax brackets; the federal corporate income tax system is flat. s, but it is not currently subject to withholding. Self-employment income also would not be subject to exact withholding.
Return-Free Filing and the Tax GapThe tax gap is the difference between taxes legally owed and taxes collected. The gross tax gap in the U.S. accounts for at least 1 billion in lost revenue each year, according to the latest estimate by the Internal Revenue Service (IRS) (2011 to 2013), suggesting a voluntary taxpayer compliance rate of 83.6 percent. The net tax gap is calculated by subtracting late tax collections from the gross tax gap: from 2011 to 2013, the average net tax gap was around 1 billion.
Many have made the argument (myself included) that return-free filing would reduce the tax gap, or the difference between the amount of taxes owed and taxes collected. And there’s some analysis to support this: in 1996, a Government Accountability Office (GAO) report found that some form of return-free filing would save the IRS roughly $36 million by reducing errors. After adjusting for inflation and income growth, presumably that number is significantly higher now.
But the current tax gap is estimated to be around $630 billion. Even if the savings would be about twice as high now, it would only account for a tenth of a percent of the tax gap. The main reason the magnitude of this change is so small is that the types of income that would be subject to exact withholding already have low noncompliance rates. There is only a 1 percent underreporting tax gap for employee wages. However, income with higher noncompliance rates, like partnership income, would not be affected by the return-free filing system.
These aren’t the only concerns with return-free filing. Making the IRS, now the tax collector, also become the tax preparer could create a misalignment of incentives and lead to taxpayers making overpayments. Conversely, some (including advocates of the idea, like Stanford law professor Joseph Bankman) have argued that it would lead to more underpayments, as taxpayers would challenge an IRS overestimate of liability, but not say anything if the IRS underestimated. In more abstract terms, the process of tax filing arguably holds some civic value and removing the taxpayer from much of the filing process reduces transparency.
At the end of the day, return-free filing could reduce compliance costs for many taxpayers, but would only be as good as the system it is administrating. Significant reforms to the haphazard set of policies administered through the tax code are a prerequisite for return-free filing being a truly effective reform.
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