The Cost of Complying with the Federal Income Tax
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Special Report No. 114
Executive SummaryMost Americans naturally think of their income tax burden simply as the amount at the bottom line of their 1040 form. Economists, on the other hand, may express Americans’ tax burden as a percentage of GDP or even as a date on the calendar, such as Tax Freedom Day. But such measures fail to register another cost to taxpayers: the cost of complying with the Federal income tax system. Over time, the cost of tax compliance has grown tremendously due not only to the inherent difficulty of taxing income, but also to the growing non-economic demands being placed on the tax code.
In 2002 individuals, businesses and non-profits will spend an estimated 5.8 billion hours complying with the federal income tax code (henceforth called “compliance costs”), with an estimated compliance cost of over $194 billion. This amounts to imposing a 20.4-cent tax compliance surcharge for every dollar the income tax system collects. By 2007, the compliance cost is estimated, conservatively, at $244.3 billion. However, this estimate does not take into account the recently enacted Economic Growth and Tax Reform Reconciliation Act (EGTRRA) of 2001. Taking EGTRRA into account shows that the compliance cost could soar as high as $350.2 billion by 2007.
In addition, the compliance cost does not impact all taxpayers in the same way—it varies by type of taxpayer, by income level and by state. In 2002, businesses bear the majority of the compliance cost with 52.8 percent of the cost, or $102.5 billion. Individuals and non-profits account for the remaining compliance cost—at 44.4 percent ($86.1 billion) and 2.8 percent ($5.4 billion), respectively. By 2007, the percentages remain virtually the same: businesses at 52.4 percent, individuals at 44.8 percent, and non-profits at 2.9 percent.
When examined by income level, compliance costs are found to be highly regressive. In other words, lower income taxpayers pay more in compliance costs as a percent of income than do higher income taxpayers. For example, for taxpayers with Adjusted Gross Income (AGI) of less than $20,000, their compliance costs amounts to 4.53 percent of income while the compliance costs on taxpayers with AGI of over $200,000 amounts to 0.29 percent of income.
State-by-state estimates of the 2002 compliance cost are also dissimilar for a variety of economic and demographic reasons. On a per capita basis, states such as Maryland, Delaware and New Jersey face the highest compliance cost while states such as Mississippi, West Virginia, and New Mexico face the lowest compliance cost. On a per $1,000 of income basis, the relative order changes with states such as Montana, Utah, and Wyoming facing the highest compliance cost and states such as California, Massachusetts, and Connecticut facing the lowest compliance cost.
It is important for the public to have an estimate of their compliance costs because the performance of the economy is dramatically affected by the state of tax law. If lawmakers create an Internal Revenue Code that is terribly complex or that changes rapidly, taxpayers may not be able to obtain a reasonably certain conclusion about how taxation will affect a business plan or investment. When the tax consequences of various economic activities are unpredictable, then tax policy is handicapping the growth and dynamism of the U.S. economy.