income tax

What if You Didn’t Have to File a Tax Return?

Jeremy Horpedahl4 Comments

Now that we’ve all made it through the 2021 tax filing season, it’s worth thinking about a recurring question in tax policy: is it possible that most of us wouldn’t need to go through this annual ritual? Couldn’t the government just tell us how much we owe (or are due as a refund), or better yet, just deduct the correct amount from our paycheck so we’d have paid the right amount?

We need to imagine such a system: it exists in many developed nations around the world! And it’s true that, at least for many taxpayers, the IRS already has all the information on you it needs to calculate your taxes.

But how many US taxpayers would this be beneficial for? A new working paper which tries to quantify this question. In “Automatic Tax Filing: Simulating a Pre-Populated Form 1040,” the authors use a large sample of tax returns to estimate how many taxpayers a pre-filled return would work for. The results are almost split down the middle: it would work well for maybe half of US taxpayers (41-48% of taxpayers, depending on how we are defining successful). For the other half, it wouldn’t give you an accurate estimate of how much tax you owed.

And the errors can be large. For example, the authors report that “two-thirds of the cases where the lower bound approach is inaccurate, the pre-populated liability is higher than the reported liability, with a median gap of $4,200.” Note: looking at the tables, I think they mean to say “mean,” not “median” here, with the median being $1,400. Still, that’s a lot of errors in a direction that would hurt taxpayers if they didn’t fill it out on their own or pay someone to do it. And it’s not just one thing that’s causing pre-filled returns to be wrong. You might think itemized deductions are a big issue, and they are, but only for about 11% of returns (and in only 4% of returns is this the only issue). They find that 9% of returns didn’t even have the reported wages matching what the IRS showed!

Does this mean that pre-filled returns are doomed in the US? Perhaps not! They seem to work much better for younger, single filers, and as well as filers with very low income, as Figure 1 from the paper shows. Even so, the 60-80% success rate (depending on criteria) for very low income taxpayers isn’t especially encouraging. But one upshot of a pre-filled return is that there are possibly millions of taxpayers (maybe 8 or 12 million?) that don’t file a return because they aren’t legally required to (too low income), but they would benefit if they did because of refundable credits like the EITC and Child Tax Credit.

Maybe there is a compromise position. The IRS could send you a “suggested tax return,” but allow you to modify it. I suspect that, in most cases, those who are currently paying for a person or software to do their taxes would still do it. You can’t know if you are in the one-half of taxpayers where this information is accurate! The IRS could provide a list of “common reasons why you may be in the half of pre-filled tax returns that are wrong,” but we’re still shifting the burden back to the taxpayer.

I would like to suggest, instead, that there are a few changes we could make to our tax system (“simplifications,” if you will) that might make pre-filled returns much more viable.

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What Is Income?

Jeremy HorpedahlLeave a comment

The United States, like nearly all countries, has an income tax. What is an income tax? It’s a tax on income. What is income? That’s actually a very hard question.

The question comes up in a recent report by ProPublica on the taxes that very wealthy Americans pay (I’m not going to link to it, because the data was likely illegally obtained, and almost certainly immorally obtained, but you can easily find it). What’s really interesting is that never define income, but they do have an implicit definition which includes changes in net wealth. More on this later, but it does raise an important question under an income tax: what exactly should count as income?

For most wage and salary workers, income is fairly straightforward. It’s the compensation that your employer pays you in exchange for your labor services. Easy enough. There are some wrinkles. For example, most non-cash compensation is not considering income for tax purposes. And even some cash compensation, such as contributions to retirement plans, are not considered income. Still, pretty straightforward.

But what if you own a business? It gets a little more complicated. We could define your income as all of the money you receive when you sell goods and services to your customers. But that has a few problems. Let’s say you run a restaurant. You sell burgers for $5. Should you pay income tax on every $5 burger you sell? Keep in mind that you probably had $4.50 in expenses to sell that burger. You bought the beef, buns, and condiments. You paid your workers. You paid to “keep the lights on” (that’s how small business owners refer to utilities and other overheard). So our income tax system will only tax you on the $0.50 difference, which we usually call profit (in some years, of course, businesses have costs that exceed their sales revenue, in which case they owe no income tax).

Now for the really hard question: what if most of your income is derived from assets that you own? That’s where things get even more complicated, and both legal and philosophical questions come up.

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What’s the Worst Tax?

Jeremy Horpedahl2 Comments

It’s the most wonderful time of the year, when we start to get all those little documents in the mail and electronically showing how much you earned in the past year. The purpose of these little documents, of course, is to complete your federal and state income tax returns. While many Americans dislike paying income taxes, there is another tax that is rated as even worse in surveys: the property tax.

Why do Americans dislike the property tax so much? One popular explanation is that people don’t like the idea that “you never really own your property.” In other words, even after you have paid off your mortgage, you must continue to pay property taxes, which feels like a form of “rent” that you pay to the government. Of course, that “rent” does pay for a variety of public services, primarily K-12 education in most locations, but this still seems to rub many Americans the wrong way. The libertarian phase “taxation is theft” conveys a similar sentiment for income taxes, that you never “really own” your own labor if you must pay taxes on your earnings.

But there is also an economic explanation for the hatred of the property tax: it is very salient, especially to taxpayers that no longer have a mortgage. While those of us that still have a mortgage on our home pay property taxes through our normal monthly mortgage payment, Americans that have paid off their mortgage typically write a check (or two) to pay the full amount of their property tax bill. An interesting paper by Cabral and Hoxby finds that jurisdictions with more taxpayers using escrow for their property taxes (meaning they have a mortgage) also have higher property tax rates. And furthermore, they “find that owners with tax escrow report their taxes much less accurately than those without tax escrow” (look at Figure 2 in the paper to see the huge differences).

Income taxes, on the other hand, are not salient for most Americans. Payroll withholding means that the taxes are taken out before we even get our paycheck, and you’ll only notice them if you look at your pay stub. And about three-quarters of US taxpayers get a tax refund at the end of the year. For most Americans, the only salient part of the income tax system is a check they receive as a refund, rather than writing a check for their property taxes.

What does all this mean? Should income taxes be made more salient? Should property taxes be made less salient? A simple answer could be that all taxes should be equally salient. Or if you view one tax as superior in some way, maybe that tax should be less salient, so there is less opposition to it.

I don’t have the answers to these questions. But I do have a question for readers: do you know your own income tax rate? Specifically, what is the marginal rate on your federal income taxes? I invite readers to write down their guesses, then look up the correct answer. How close were you? Please leave a comment, and be honest!