November 1, 2000

The Cost of Complying with the U.S. Federal Income Tax

Download Background Paper No. 35


Background Paper No. 35

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 tax system.

This study estimates how much it costs both individuals and businesses to read the rules, fill out the forms, and do all the other things necessary to comply with the nation’s tax laws.

It is important for the public to have an estimate of this cost 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. In fact, the U.S. income tax — the core of our government’s tax system — is one of the most complex legal structures currently used for taxation by any government in the world.

Income tax complexity is almost wholly related to tax base questions — that is, questions or uncertainty about the timing or definition of taxable transactions. In other words, an income tax is inherently complex because it is so difficult to define income and determine when to recognize income and expense for tax purposes. Over time, the political give and take has made these difficult tax base questions inordinately complex. The definition of taxable income has not only expanded dramatically, but it has undergone chronic change.

As if the complexities inherent in taxing income did not pose a sufficiently daunting challenge to the writers and administrators of the tax code, political and social demands must also be taken into account. In particular, two goals for the code that contribute to complexity are “fairness” and social utility. They come into play when determining how much individual taxpayers should owe— the “ability-to-pay” principle, and when providing incentives for socially beneficial activities.

Many studies of the tax code find that our system, particularly the income tax code, is excessively complex. This study concurs, quantifying the code’s complexity in a way that makes clear how unnecessary much of it is.

In 1999 individuals and businesses spent over 4.3 billion hours complying with the federal income tax, with an estimated cost of compliance of over $125 billion. This amounts to imposing a 12-cent administrative burden for every dollar the income tax system collects.

If the high cost of complying with the federal income tax were a necessary price to pay for a fair and effective tax system, perhaps there would be little room for complaint, but in fact the complaints are justified.