The U.S. Tax System: Here’s How Messed Up It Is

Imagine you’re at Walmart, shopping for something expensive, such as a lawnmower or computer. You have two pricing options. You can either accept a discount price 15% below the manufacturer's suggested retail price and be done with it, or choose a more complicated plan that might be worth as much as 30% off. But you’d have to apply for rebates, wait for months to get the money back and possibly hire a consultant or two to help you navigate the complicated paperwork. If you miss a deadline or fill out a form incorrectly, you could end up saving less than under Option 1.

Yahoo! Finance
Yahoo! Finance

That complicated choice is basically a description of the U.S. tax system. As most Americans know, the tax code has become hopelessly complex, with an encyclopedia’s worth of exclusions and workarounds that favor one percenters and big companies able to hire the best tax professionals. Inefficiencies require higher tax rates than necessary while generating far less revenue than the government actually needs. There’s one other gloomy consequence of a convoluted tax system: It makes Americans distrustful of the government and less likely to support measures that might actually make things better.

There’s considerable pressure to simplify the tax code and make it more efficient, since, in theory, that might boost the U.S. economy with little or no cost to taxpayers or the government. President Obama would love to be able to tout sweeping tax reform as one of his second-term accomplishments. His Republican adversaries on Capitol Hill might get the lower tax rates they’ve been advocating for years. Businesses would benefit from lower compliance costs, while ordinary workers would welcome anything that reduces their tax bite or makes paying taxes less irritating.

Setting the stage

To set the stage for meaningful tax reform, officials in Washington are beginning to execute a takedown of the current system, which was crafted by some of the very same people now calling for its overhaul. The Government Accountability Office, for instance, just released a report showing that big corporations paid federal taxes at an average rate of about 13% in 2010 (the latest year for which there’s data), even though the federal tax rate is 35%. Corporations are able to claim so many credits and deductions that the starting tax rate is almost meaningless. Further distortions give advantages to companies able to perform more of their work overseas, since they can often set up subsidiaries in countries with the lowest tax rates. U.S. companies that do most of their work domestically, such as healthcare or real-estate firms, tend to pay more in taxes, as if there’s a penalty for serving Americans rather than foreigners.

The corporate tax structure is so flawed that fixing it is one of the rare issues Democrats and Republicans generally agree upon. Obama is willing to lower the tax rate to 28%, provided most loopholes are closed. Republicans favor a rate of 25% or lower, while generally agreeing on the need to sew up loopholes. If the two parties could stop spitting at each other for a couple of months, they might actually be able to fix the corporate tax code.

The two parties are farther apart on problems relating to personal income taxes, which account for 46% of the government’s revenue, nearly five times the take from corporate taxes. Like corporations, most individuals pay taxes at a far lower rate than their tax bracket dictates, because of numerous deductions for things such as the cost of childcare, mortgage interest, state and local taxes, charitable contributions and the like.

Senators Max Baucus (D-Montana) and Orrin Hatch (R-Utah) are now trying to generate momentum for tax reform by pointing out the many complexities of the tax code to their Congressional colleagues and introducing reform legislation. In a recent open letter, for instance, they point out that, since the last big tax reform effort in 1986, Congress has changed the tax code 15,000 times, with the cost of hiring professionals to help abide by all the rules now totaling $160 billion per year. That’s the equivalent of a dozen aircraft carriers.

"Clean slate" reform

Baucus and Hatch are calling for “clean slate” reform that starts with the lowest possible rates and no loopholes, deductions or credits, layering in only those deemed essential to the U.S. economy. As they detailed in their letter, every tax break pushes up tax rates, forcing both individual and corporate taxpayers to seek even more tax breaks, resulting in the expensive hide-and-seek system we have now.

Even though nearly everybody realizes how messed up the U.S tax system is, fixing it will be difficult, maybe impossible. Partisan discord can sink any issue in Washington these days, and there remains large ideological differences about what kinds of changes are best for the economy. Despite what they say about the need for reform, many politicians benefit from the current system, which generates millions in political donations from lobbying groups seeking tax favors and provides a strong incentive to keep the status quo intact.

One thing that may make reform more likely is the recent scandal involving IRS scrutiny of political groups. “The scandal is a timely and stark example that illustrates the extent of the problems with the current system,” Washington consulting firm Gogerty Marriott wrote in a recent analysis. “It is so overly complex that it can be ‘gamed’ by corporations [and] taken advantage of by agenda-driven agencies.” The question now is whether they will game tax reform, too, or let the little guy get a good deal for once.

Rick Newman’s latest book is Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.