The "Everyone Uses Turbo Tax" Fallacy

Matt Yglesias yesterday picked up on a point I made in parentheses the other day: That a flat tax (that is, a system with a single marginal rate) is not necessarily a simple tax, and a progressive tax (multiple marginal rates, rising with income) is not necessarily complex. The complexity, he notes, comes from the complicated definition of income. He points out that for anyone who uses Turbo Tax, the number of rates is invisible.

And a commentor noted that you don't even need Turbo Tax to make a progressive tax system simple. You can just use the tax table and fill in the number on the proverbial postcard, as long as the definition of AGI is not too complicated. But Turbo Tax also hides some of the complexities in that definition, and in the different rates for dividend and capital gains income that have been introduced into the tax code in the last three years.

The Washington Post, in a personal finance story over the weekend, described the current tax code well:

The [four tax bills of 2001-2004] have taken a tax system that was already complicated enough and turned it into a kaleidoscope of annually changing brackets, limits and rules.

Provisions blink on and off like lights in Times Square. Benefits scheduled to expire are extended -- or allowed to expire and then extended. Benefits scheduled to phase in are suddenly accelerated, but their scheduled expiration date is left in place.

Simplification has always been one of the key principles of tax reform, but the argument that "everyone uses Turbo Tax" takes some of the steam out of the argument. That's unfortunate, not only because the tax code has become staggeringly complex, but because simplification helps strengthen some of the other elements of reform, especially the argument for the type of fairness known as horizontal equity -- treating similarly situated taxpayers similarly. Abandoning simplicity as a goal also means that tax reform, unless it cuts taxes for a significant portion of the population, which is not possible now, doesn't have much to offer average voters.

But I would still put a high priority on simplification in one area: simplification for low-income workers. Over the last few decades, we've shifted much of our social policy to the tax system, partly because tax breaks are politically easier to sell than direct spending, but also as part of shifting from a broad social safety net to a system of support linked to work. The payoff to work as opposed to welfare is now, in theory, much higher than in the past, and the combination of the Earned Income Tax Credit, the Child Credit, the Dependent Care Tax Credit, and the refundable Additional Child Tax Credit can put real dollars in the pockets of low-income working families.

It does so at a cost: enormous complexity for low-income families, the people least likely to use Turbo Tax, and who shouldn't need to use Turbo Tax. The four different credits intersect in complicated ways, and treat income in unusual ways. Even within Turbo Tax you can see the complexity for low-income families. It used to be that in the course of doing my taxes, usually on paper, I would look at some forms or deal with various questions from the software that looked very complicated, and realize with relief that I don't need to deal with that because that's for rich people. Now I look at forms like the Additional Child Tax Credit, and breathe a sigh of relief that I don't have to deal with that nightmare because it's for poor people. Whether tax rates rise with income or not, I think it's reasonable to expect that complexity should be much less at the low end than at the high end. Yet the opposite is case since 2001.

This complexity also sucks away a huge amount of the value of the tax credits that have become the main way to support low-income working people. The complexity drives people to tax preparation services, which not only charge their own fees (average, $120), but also encourage people to take Refund Anticipation Loans, which as far as usury goes, makes the credit card industry look like UNICEF.

As I was writing this I started to look into Refund Anticipation Loans, which I knew were not a good thing, but I didn't know the half of it. According to the National Consumer Law Center, 12.15 million taxpayers took these 7-14 day loans in 2003, paying effective interest rates that ranged from 70% to over 700%. Half of the people who took these loans were recipients of the Earned Income Tax Credit. Almost 80% had household incomes below $35,000. A majority didn't realize it was a loan. Tax preparation fees combined with RAL fees average about $250. When you consider the big deal that was made about a $600 child credit, you can see how much is lost through this scam.

It's worth noting that these "loans," unlike the credit card debt at issue in the bankruptcy bill, are made at zero risk to the lender,

One approach this scam is to try to stop tax preparation firms like H&R Block and Jackson-Hewitt from promoting these schemes, or to force them to reduce their fees, which apparently ACORN and the Children's Defense Fund are succeeding at doing. The firms probably rationalize that if they can keep collecting the tax prep fees, they can live without some of the RAL business. But we can also strip away the demand for these services. A basic principle for tax reform should be that family earning less than the median income, principally from wages and salaries, should not need any help preparing their taxes. That could be achieved with a single unified credit incorporating the various aspects of the four main credits, as well as others, in the simplest formula possible. (Max Sawicky has been pushing this for years.) Among other benefits, it would ensure that the government gets its money's worth for this investment, rather than sending a huge portion of it to the tax preparers and refund lenders.