Chicago Booth Review Podcast Is the Tax Code beyond Fixing?
- April 05, 2023
- CBR Podcast
It may be in the nature of taxation that it should suffer a bad public image—but US law, with its convoluted tax code, doesn’t help make it any more palatable. Why is it so complicated, particularly when simplifying it is one of the rare ideas that enjoys bipartisan support? And apart from making it more straightforward, how else might lawmakers improve it? This episode of the Chicago Booth Review Podcast examines three CBR articles exploring research around taxation from different angles.
Hal Weitzman: One of the few things that Democrats and Republicans agree on is that the US tax code should be simpler. That’s usually where the consensus ends. Republicans typically focus their efforts on trying to lower tax rates, while Democrats often highlight the need to close loopholes in the tax system.
Welcome to the Chicago Booth Review podcast, where we bring you groundbreaking academic research in a clear and straightforward way. I’m Hal Weitzman, and in this episode we dig into one of life’s inevitables—taxes.
Every policymaker wants to give tax breaks to reward certain kinds of activities, from switching to induction stoves to saving for college. The result is that even though we all say we want a simpler tax code, the system gets more and more complicated. Does it have to be this way? We posed that question in a 2018 feature that looked at how the tax code changes behavior and what effect it has on our society. The story was titled, “Why It’s So Hard to Simplify the Tax Code.” It was written by CBR contributor Dee Gill, and it’s read by Julie Granada Honeycutt.
Reader: When Republicans in Washington, DC, started talking up the latest round of tax reform, they said they were aiming for something so simple that 90 percent of US households could essentially file their taxes on a postcard. US Representative Kevin Brady (Republican of Texas) held up a prop, a mock-up of such a tax postcard, to drive the point home.
And simplifying the tax code ostensibly has bipartisan backing. Both the Bush and Obama administrations advocated for simplification, in reports, as have House Speaker Paul Ryan (Republican of Wisconsin) and Senator Elizabeth Warren (Democrat of Massachusetts). But when the Senate passed a tax bill this past December, there was no postcard. Instead, Democrats pointed to handwritten notes in the margins of the bill as a sign of a madcap construction process going on. Proposals to cut deductions for home mortgages and medical expenses, and tax credits for adoption and education, had been met by pushback. “File Your Taxes on a Postcard? A GOP Promise Marked Undeliverable,” pronounced a New York Times headline shortly before President Trump signed the bill.
What happened? The same thing that always does, suggest researchers. While simplicity is a stated goal, complexity wins the day. Hence companies and individuals will hire accountants to wade through the latest bill, interpret the new rules, offer guidance, and help work through the inevitable corrections and amendments.
And this comes at an economic cost. Research by James Mahon and Chicago Booth’s Eric Zwick, and others, collectively indicates that the complexity leads individuals and companies to fail to take advantage of billions of dollars in offered breaks, many of them presumably intended to stimulate the economy. In this way, complexity undermines what tax incentives are purported to accomplish.
The tax-reform cycle
The US tax code is a master class in convolution. Individuals are taxed at different rates, and they can reduce their effective rate through myriad credits and deductions, which take time to itemize if they choose to do so. Companies’ stated tax rates depend on their structure, and companies, too, have opportunities to change their effective rates.
The Tax Reform Act of 1986 memorably promoted simplicity as one of the three core reasons for pursuing a system overhaul, the others being efficiency and fairness. According to a 10-year analysis of the act by University of California at Berkeley’s Alan J. Auerbach and University of Michigan’s Joel Slemrod, the act “had mixed success in reducing complexity.” It registered some clear wins, such as nearly eradicating the tax-shelter industry, and temporarily eliminating the tax differential between capital gains and ordinary income, “which many tax lawyers had argued was the largest cause of transaction complexity in the pre-TRA86 tax code,” the researchers write. But other changes fell flat. Taxpayers kept paying for professional tax assistance, an indicator of the code’s complexity.
Since then, the calls for simplicity have continued. Some call for simpler but more regressive tax structures such as a retail-sales tax, a value-added tax (which levies a tax at every stage of an item’s production and distribution), or a flat tax that would give all individual taxpayers a single rate. But to date, tax reform has never reversed the complexity trend. Other than the 1986 act, “I am not aware of any other major tax legislation that had simplicity as a stated objective, which makes it unlikely that simplification resulted,” says Auerbach. “Indeed, the general movement over the years toward using the tax system to accomplish various policy objectives, through the use of so-called ‘tax expenditures,’ has led to greater complexity.”
Walking away from billions
What’s making the code so convoluted? As Auerbach notes, politicians have taken to using tax breaks to encourage employers to hire more people (or at least not fire them), buy equipment, and otherwise invest in creating jobs. They use other breaks to push people to pursue education that would raise their wages, borrow money to buy a home, and send children to day care while parents work. When these incentives function as intended, more money flows into the economy through rising wages and spending, which generates more funds for the US Treasury at tax time.
But tax breaks only change behavior if people claim these breaks—and many don’t. The Internal Revenue Service notes that one in five eligible workers doesn’t take advantage of the Earned Income Tax Credit (EITC), a program that tax-policy groups consider effective for pulling low-income families out of poverty. And, according to the Brookings Institution, there are only “relatively modest” take-up rates for the Saver’s Credit, the Child Tax Credit, and the American Opportunity Credit, which is up to $2,500 cash toward college tuition.
Mahon and Zwick find that companies, too, are leaving money with the government. They look at the carryback, a permanent tax break in the US code designed to act as an ongoing economic stabilizer. The carryback lets companies claim refunds for net operating losses, which ostensibly encourages healthy companies to continue spending and employing people during rough years. Most US corporations have been eligible for carryback refunds at some point.
Congress twice beefed up potential carryback payments specifically to stimulate the economy in recessions, and many companies took advantage of the relief as intended. In one example, during fiscal 2010, a particularly dire time for many American manufacturers, Applied Materials collected $130 million for the carryback of heavy losses recorded in 2009, the researchers note. The company went on to grow dramatically, perhaps aided some by the tax relief.
But these tax-break expansions could have helped many more corporations than they did, particularly during the Great Recession, according to Mahon and Zwick. The researchers culled 1 million corporate tax filings from 12 million companies between 1998 and 2011. Each filing in their sample was eligible for at least one carryback claim of at least $1,000. In 2008 and 2009 alone, US corporations were eligible for $124 billion in carryback refunds but claimed only $68 billion.
Only 37 percent of corporations eligible for refunds claimed them, the researchers find. Thousands of companies didn’t file claims, leaving $170 billion in potential carrybacks unclaimed. Eligible carryback claims for the period totaled $357 billion between 1998 and 2011, according to the study, but only $187 billion in claims were collected.
For many companies, the size of the claim didn’t appear to be a deciding factor. The take-up rate rose with the relative value of the claim, but only the very largest corporations had take-up rates exceeding 50 percent. Companies big and small left money unclaimed. Of only the larger companies eligible for refunds of more than $100,000, one in four didn’t pursue the claim. For small and midsize companies eligible for refunds of more than $10,000, half of the refunds went unclaimed.
The companies that opted out of a carryback claim didn’t do so in order to get some other cost benefit, such as from carrying forward losses, the research finds. They simply let the government keep their money. Even after allowing for the expenses involved in paying professionals to file a claim, the value of the carryback exceeded the cost for most refunds in the study sample.
Why complexity is at fault
The researchers reason that complexity must have caused the companies to leave all those billions unclaimed. For one thing, companies that had sophisticated accounting help were more likely to claim a carryback.
Filing a carryback claim takes an average of 16.5 hours, according to IRS data used in the study. Much of the time is spent figuring out how much can be collected. The process includes filing a form to document how the refund was calculated, which essentially requires redoing past tax returns.
More-complicated past returns are more likely to require additional computations, which leads to a higher likelihood of more interaction with the IRS, related either directly to the carryback claim, or to past returns that are otherwise under audit. IRS audits, which occur annually for large companies and are common at smaller ones, can take years to clear. Disputes over carryback claims alone can take years to resolve.
Companies that hired certified public accountants and attorneys to prepare and file their taxes were more likely to file carryback claims. Compared to a 37 percent claim rate for all eligible filers, 42 percent of eligible companies that hired an outside attorney filed carryback claims, and the figure was 45 percent for companies that hired CPAs.
And more sophisticated preparers also seemed more likely to file claims. Older preparers and accountants who had bigger client bases were more likely to seek carryback refunds. Preparers who worked for themselves were less likely to.
Big companies generally hire sophisticated preparers, so Mahon and Zwick studied claim patterns of smaller companies that were both eligible for multiple carryback claims between 1998 and 2011 and had switched tax preparers during these years. To minimize the possibility that a corporate management change led to changes in tax strategies, the researchers focused findings on switches that occurred when the tax preparer either died or moved at least 75 miles away.
The researchers conclude that characteristics of the tax preparer mattered as much to the decision to file a carryback claim as intrinsic characteristics of the company itself, such as asset and loss size. More sophisticated preparers—which the researchers identified in part as those who had more official training, experience, and clients—filed more claims.
Meanwhile, large companies’ actions were also affected by tax issues not directly related to carryback claims. Companies that paid the corporate alternative minimum tax, for example, were considerably less likely to claim a carryback refund. Technically, the alternative minimum has nothing to do with the carryback—it’s meant to ensure that profitable corporations pay some tax even after deductions, and it’s irrelevant for most small and midsize corporations. However, a carryback claim adds to the accounting time required for an alternative minimum filing. Separate accounts are required for regular tax and alternative-minimum calculations, including accumulated stocks of carrybacks, which can alter the ultimate size of a potential refund.
Thus the decision not to file carrybacks was driven not by the carryback provision itself, but by broader tax-code complexity, the researchers conclude. The companies that claim the alternative minimum may simply decide they don’t want to risk complications with this filing, or add to their accounting expenses, by also claiming carrybacks. And other companies only filed claims when sophisticated preparers guided them to do so.
Complications decades in the making
While Mahon and Zwick focused on corporations, other studies find that tax-code complexity also reduces take-up of provisions aimed at individuals. Taxpayers underreact to or even ignore new tax laws when incentives are complex, even when the potential gains are high, according to a 2015 study by University of Oxford’s Johannes Abeler and MIT’s Simon Jäger.
In an experiment run by Abeler and Jäger, each participant could earn a payment for sliding icons on a screen into position. One group was told they would receive a piece rate, and pay a steadily increasing tax, for each correctly positioned icon. A second group was given the same job with the same piece rate but with more-complex incentives and tax rules—they had 22 rules versus two. Before the task began, every study participant decided his or her optimal number of completed sliders.
New incentives, identical in each group, were added in subsequent rounds. Subjects who started with the more complex system were less likely to react well to the new incentives, and thus earned significantly less money, according to the findings. They were more likely to simply stick to their previous calculations of how to maximize their returns, even when the rewards for adjusting their productivity were large.
A separate study, published in 2015, finds that simplifying the information provided to potential recipients of the EITC greatly improved take-up rates. The refund is intended to support low-income earners, but as of 2005, roughly 6.7 million low-income taxpayers who could boost their take-home earnings with the credit did not claim it, leaving, on average, 33 days worth of pay with the government, note Carnegie Mellon University’s Saurabh Bhargava and University of Texas at Austin’s Day Manoli.
The researchers worked with the IRS to mail additional EITC information packets to 35,000 likely eligible taxpayers in California who had failed to claim the credit. Both the original and subsequent mailings contained worksheets that could be filled out and returned for refunds. There were a number of different experimental versions of the mailings and worksheets, one of which simplified the original two-sided, text-dense information sheet onto one page with larger font. The packet also included a simplified version of the original worksheet. A control group received a repeat of the original notices.
While follow-up notices of any kind boosted claims, a notice with a simplified layout significantly boosted take-up, the researchers find. “Small changes to the design and simplicity of these forms can induce large responses among otherwise intractable populations,” notes Bhargava. “The share who fail to claim these valuable benefits could be significantly reduced by clearer, shorter, and simpler forms.”
But current take-up rates indicate that the EITC has yet to fulfill its potential as a social-welfare tool that can help minimize poverty and promote a healthy economy. And the research collectively suggests that the effects of many tax incentives are likely muted. Forecasters—whether predicting the number of families who will collect food subsidies, or the number of jobs that a corporate tax break will create—generally assume that people and companies act in their own best interests, but if complexity prevents them from doing so, the benefits don’t have the intended effects.
This leads to a predictable cycle. When benefits don’t have the intended effects, lawmakers put more benefits and incentives in the code. Yet these additional benefits and incentives make the code more complex, so people and companies don’t claim them. And this further undermines what the benefits are there to do. But it leads to a clear takeaway: to effect economic change with tax laws, it would help to make the laws simpler.
This assumes, however, that economic change is the intended goal. “There is some argument for complexity,” says Stanford’s John H. Cochrane, who is also a distinguished senior fellow at Booth. “By making a tax advantage available but very obscure, the government can give it to a narrow group that really cares and count on others not figuring it out. . . . I call it price discrimination by needless complexity.”
What about that bipartisan support for simplification? Overstated, suggests Auerbach. The goal of a simpler code ranks “right up there with motherhood and apple pie,” he says, “as long as it’s an abstract objective.”
Hal Weitzman: So everyone hates the tax code, and none of us really enjoys paying taxes. But if we have a particular social goal in mind—say, reducing inequality—research suggests that we’d rather pay to pursue that goal using taxes rather than donating money for the same end. We wrote about it in a 2022 piece under the headline, “To Address Inequality, Donors Prefer Taxes to Charity.” The story was written by CBR contributor Rose Jacobs, and it’s read by Julie Granada Honeycutt.
Reader: A growing chorus of critics argues that philanthropists get too much praise—and too many tax breaks—relative to the good they do in the world. Government funding for science, the arts, and poverty reduction outstrips charity by trillions globally, and whether Bill Gates is better than bureaucrats at picking the worthiest causes is hardly a settled contest.
As for raising money to reduce inequality in particular, most people tend to favor taxes over donation requests, making taxation a preferred way to redistribute wealth even from the givers’ perspective, according to George Mason University’s Johanna Mollerstrom, Chicago Booth’s Avner Strulov-Shlain, and University of California at Berkeley’s Dmitry Taubinsky.
“These results suggest that government programs, such as progressive tax-and-transfer systems, can help satisfy other-regarding preferences for redistribution in a way that creating opportunities for voluntary giving cannot,” the researchers write.
Mollerstrom, Strulov-Shlain, and Taubinsky ran a series of online experiments involving 1,600 American and Canadian subjects, testing participants’ willingness to donate their own money in changing settings. The researchers find that, as long as subjects with relative wealth $3.50 versus 10 cents) had a say over only their own giving, no more than a third were willing to donate as much as $1.20 to members of the poorer group.
This was in contrast to scenarios in which the rich participants could influence whether their rich peers would also have to part with cash—by voting for or against money being redistributed more fairly. In these cases, about half voted in support of transfers from rich to poor.
Many people seem to agree that “equitable allocation of resources is an intrinsic public good,” the researchers write, but their findings suggest that people really prefer collective action to striking out on their own. Governments that put tax money toward reducing inequality “can help people implement their taste for redistribution in situations where the desire for voluntary giving is too weak to achieve the equitable outcomes that many desire,” Mollerstrom, Strulov-Shlain, and Taubinsky argue.
Their research results also highlight how findings derived from small study samples may not translate well to policy: in an experiment they conducted to test whether the size of groups might change the outcomes, they find that participants’ willingness to donate declined as the number of potential beneficiaries rose. Only one in six rich participants donated when 100 people were due to share the spoils, compared with one in three when the recipients were in more intimate clusters of four. This size effect might explain why a relatively high propensity toward charitable giving seen in laboratory experiments does not always play out in real-world scenarios, the researchers argue.
The only condition under which the portion of participants willing to make personal donations matched the portion voting in favor of a wider tax on the rich was when the potential donors were told the money they donated would land entirely with one “partner” in the poorer group with whom they had been paired. The researchers posit that this effect came about because the language of partnership effectively reduced the group size in the minds of the donors.
Hal Weitzman: A couple of goals that the US tax system does have in mind are encouraging both entrepreneurship and home ownership, and it’s partly for that reason that capital gains are taxed at a lower rate than earned income. Capital gains are the profits made when selling investments such as stocks, bonds or real estate, and their lower tax rates are a source of contention. So in a 2021 essay for Chicago Booth Review, four academics analyzed the costs and benefits of raising the tax rate for capital gains. The authors were the Yale’s Natasha Sarin, Harvard’s Larry Summers, Owen Zidar of Princeton, and Chicago Booth’s Eric Zwick. Their essay was titled, “Could the US Raise $1 Trillion by Hiking Capital Gains Rates?” and it’s read by Julie Granada Honeycutt.
Reader: Capital gains taxes are a perennial issue in US tax-reform debates. Some people maintain that preferential rates on capital gains encourage entrepreneurship and capital formation, while others question whether these benefits are worth the costs.
What are those costs, exactly? It’s clear in terms of direct fairness costs: the wealthiest 1 percent of US households accounted for two-thirds of capital gains realizations in the Federal Reserve’s 2019 Survey of Consumer Finances. However, the fiscal costs, which are estimated by the Joint Committee on Taxation, are far less clear. In the parlance of policy makers, the JCT is considered the official "scorekeeper" that decides how tax legislation "scores" if implemented. The prevailing wisdom in the taxation-scorekeeping community appears to be that the revenue-maximizing rate for capital gains is about 30 percent, which is well below both current top marginal tax rates on other income and top rates currently under debate. But in a simple exercise, we estimate that increasing capital gains rates to match the ordinary income level could raise more than $1 trillion over a decade. This illustrates the need to rethink scorekeeping in the debate.
The prototypical example of a capital gain is a share of corporate stock. An individual who bought an $18 share of Amazon when it went public could sell that share today and pay taxes on more than $3,100 of appreciation.
If the revenue-maximizing rate is 30 percent, setting a rate too far above this level will actually reduce the total amount of revenue collected, as the gains expected will fail to materialize because the dynamic response of taxpayers will dramatically shrink the tax base.
Such a response could take the form of an investor retiming a stock sale to avoid realizing a capital gain event. This certainly happens, but we suspect that in most instances the investor doesn’t avoid paying taxes on that gain entirely, just immediately. The tax is simply postponed, in which case these behavioral effects are overstated, resulting in a potentially severe underestimate of the revenue at play.
The current realization elasticity used by the JCT and others in the scorekeeping community is approximately -0.7, determined on the basis of both historical scores and more recent academic research. A crude application of this elasticity implies that if capital gains tax rates doubled (to match top ordinary income levels), only 53 percent of gains would be realized. In concrete terms, roughly $1 trillion of annual realizations would shrink to around $500 billion, and the rate hike would be scored as raising no new revenue.
However, this style of calculation neglects a material offsetting factor: medium-term retiming of realizations would offset lost revenues in the short run. Suppose that doubling capital gains rates from 20 percent to 40 percent causes realizations to occur half as often: instead of realizing gains every year, individuals realize them every two years. If assets grow at 10 percent annually, then in the low-tax regime, $100 of assets yields realizations of $10 in Year 1 and $10.80 in Year 2 (after the individual pays $2 of tax in Year 1). In the high-tax regime, $100 of assets yields realizations of $0 in Year 1 and $21 in Year 2. Despite the appearance in Year 1 of a large elasticity of realizations in response to the tax increase, total revenues over both years increase from $4.16 in the low-tax regime to $8.40 in the high-tax regime. In this simple example, without other behavioral responses, the short-term revenue score is zero, and the medium-term revenue score is double the baseline. Clearly, the latter score is more relevant for policy purposes.
There are also other indications that conventional elasticities may be overstated. For example, the composition of capital gains has shifted in recent years, so that nearly half of capital gains now accrue through pass-through and mutual-fund distributions outside of the direct control of taxpayers. It is unclear whether scorekeeping models account for compositional changes and dynamic weights.
This matters because it’s one thing to time a stock sale, but it’s harder to time pass-through gains, such as those produced by the growth of carried-interest compensation offered to general partners of hedge funds and venture-capital and private-equity firms. Partnership agreements typically require funds to be returned within 10–12 years of the initial commitment. Investors in these structures cannot time realization decisions around favorable tax environments, nor can they typically defer their gains indefinitely. It seems plausible that 30–50 percent of capital gains cannot be easily timed in response to tax changes, and if that’s the case, no matter how large the easily timed elasticity is, doubling rates to top ordinary income levels will still raise substantial revenues.
Consider, also, a few examples of how changes in the capital gains tax might affect other tax bases. Preferential tax treatment encourages avoidance in the form of misclassification of wage income for fund managers through the carried-interest loophole. Similarly, the tax code favors employee stock options, which, when held for long enough, qualify for capital gains taxation. The different treatment of capital gains and dividends affects the relative attractiveness of distributing corporate profits via share buybacks versus dividends. And capital gains tax preferences can affect the allocation of capital across industries and locations, due to sheltering opportunities such as like-kind exchanges in real estate and oil and gas, investments in Opportunity Zones, and incomplete recapture of depreciation deductions following asset sales. Reform capital gains taxation, and you thus also reduce wasteful effort by taxpayers and their planners to devote resources to circumventing tax liabilities by exploiting preferential capital gains rates and sheltering opportunities.
Some have argued that lower capital gains rates promote investment, but this case appears overstated. Among other reasons, it is hard to imagine entrepreneurs making decisions about investment and risk on the basis of the capital gains tax regime: Mark Zuckerberg was not focusing on the capital gains tax when he was in his dorm room coding up Facebook.
Given the magnitudes at stake, scorekeeping procedures employed in evaluating capital gains should be made more transparent and the subject of external professional debate and review. This transparency would facilitate discussion between professional scorekeepers and outside experts about the extent to which models can be improved and new data collected. It would also facilitate the comparison of estimates across a broader set of proposals and help ensure that consistent scorekeeping practices are applied.
Transparency is a double-edged sword. Given the importance of official scores to legislative decision-making, releasing the assumptions underlying scorekeepers’ estimations to the public would invite greater lobbying around those assumptions by supporters and critics of different reforms. Our proposal is not to open the floodgates with respect to scorekeeping writ large. A natural structure is in place: the Congressional Budget Office already has a panel of advisors who provide input on economic issues. This group or a related subgroup of experts can be convened to advise the JCT, as well as the CBO and the Treasury’s Office of Tax Analysis. It would be important for diverse views to be represented in this body, and it would be valuable to work with the full set of scorekeepers to select a panel of people who are thoughtful and likely to be taken seriously by the revenue-estimating community. Short of such a formal gathering, promoting informal conversations and collaborations between scorekeepers and academics would facilitate advancing the research frontier in the most useful directions.
Our call to action is born from a position of enormous respect and admiration for the integrity and seriousness of the scorekeepers. The ultimate goal is to continue to advance our understanding of taxpayer behavior and the revenue potential of capital gains and other tax-reform efforts to inform the policy-making process.
Hal Weitzman: That’s it for this episode of the Chicago Booth Review podcast. It was produced by Josh Stunkel, and I’m Hal Weitzman. If you enjoyed this episode, please subscribe and please do leave us a 5-star review. And for more of the latest research, visit us online at chicagobooth.edu/review. Thanks—until next time
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