Inside the Federal Hurting Machine; J. L. Payne

ments are desperately needed, and serve a vital national purpose. When government is taking in money, even from the same people it has just subsidized, the cash being col lected is seen as limp and lifeless, a surplus wealth of taxpayers who have no good use for it. The underlying cause of this remarkable lapse in reasoning is the popular urge for wishful thinking. With the exception of a few crusty reactionaries, people want to believe in government. They want to·see it as a source of hope and help, an agency that can give them college educations, art mu seums, pensions, and free medical care more or less out of thin air. To remind them that they will be forced to pay every single penny these things cost, and much, much more, is a cruel party pooper. So when it comes time to examine the injuries of tax ation' people stick cotton in their ears and tum the TV to full volume. But no government spending program can Dr. Payne is director of Lytton Research and Analysis in Sandpoint, Idaho. His latest book is Costly Returns: The Burdens of the U.S. Tax System, published by ICS Press.

be justified unless its benefits exceed the costs of taxing people to pay for it. Policy makers who approve spending programs without knowing about the costs of taxation behave irrationally. They may well be doing enormous harm to the country. The Cost of Compliance To begin our exploration, we need to distinguish between two types of costs: the cost of taxes, and the cost of the tax system. The taxes are the monies taken from the public, to be spent by government. While politicians make great efforts to hide, dis tort, or forget about this figure, at least it is known and documented. Anyone can look it up in a standard reference book. For this reason, we shall not dwell upon it here. The burdens of the tax system, on the other hand, are almost entirely unnoticed and unreported. These are the direct and indirect costs of operating the system that forces people to pay taxes. After all, the money that government collects and spends does not fly into the Treasury on wings of its own. Citizens have to be prodded, and all this prodding, and dealing with the prod ding, costs the American people more dearly than anyone has realized.

One of the main burdens of the tax system is the compliance cost: the time and energy people spend keeping records, studying tax instructions, making calculations, and filling out forms and schedules. The most com124 plete study we have of this burden was carried out by the Arthur D. Little Company at the behest of the IRS itself (which had been forced to commission the study by the 1980 Paperwork Reduction Act). The Little study found that, in 1985, businesses and individuals were spending 5.4 billion hours on federal tax compliance activities. This corresponds to 2,900,000people-the entire work force of the state of Indiana-working all year long on federal tax compliance activities. The cost of this work amounts to 24 percent of all federal taxes collected. This carefully documented figure (which is supported by several other academic studies) has been ignored in Washington. Instead of working to reduce the paperwork burden, tax administrators and Congress men keep adding to it with a steady flow of laws and regulations. Economist Joel Slem rod found that in the 1980s, especially as a result of the 1986 tax act, tax compliance burdens for individuals increased 26 per cent; the increase for businesses was un doubtedly even greater.

A number of scholars have tried to tell congressional tax managers they are sowing disaster. Economist Richard Vedder put it this way, to a Congressional committee in 1984: "If an enemy power bent on destroy ing our nation were somehow given the opportunity to devise our tax code with a goal of sapping the nation of its economic vitality . . . it could do little better than adopt our current Internal Revenue Code." Law professor Richard Doernberg flatly declares, ' 'The United States now has the most complex tax laws in the history of civilization." The Cost of Forgone Production The cost of compliance, highas it is, is not the greatest burden of the tax system. An even larger drain is the economic disincen tive cost. Ever since Adam Smith, scholars have known that taxation hurts the econ omy. It denies workers, entrepreneurs, and investors some of the fruits of their creative activity and therefore discourages their con125 tributions. Recently, economists have be gun makingcalculations about the size of the economic loss caused by the tax system.

One estimate for the entire tax system, by Charles L. Ballard of Michigan State and his colleagues, published in the American Eco nomic Review in 1985, put the disincentive effect at 33.2 percent. That is, to raise an additional $100in taxes to pay for additional spending causes a loss of $33.20 in lost production-on top of the $100 in taxes paid. Another study, reported in 1990 by Harvard economists Dale W. Jorgenson and Kun-Young Yun, put the disincentive cost for the tax system even higher, at 38.3 percent of tax revenues raised. The country saw a small illustration of how the disincentive effect operates when Congress put a tax on pleasure boats in 1990: A strong export industry was almost de stroyed and thousands of workers lost their jobs. In 1993, Congress recognized its error and repealed the tax. Unfortunately, Con gress hasn't gone further and recognized that all its taxes go on destroying jobs day after day. They add to the cost of doing business and therefore cause scores of thou sands of businesses to fail-and discourage scores of thousands of other possible busi nesses from ever being started.

The Cost of Noncompliance Another burden of the tax system is enforcement-the cost of dealing with those who don't comply with the tax code. Tax ation, we need to remind ourselves, is based on force and the threat of force. At first glance, this makes it seem an efficient way of raising money. Generations of eager spenders have embraced it with just this hope in mind: the threat of force should make the money flow in automatically. What they overlook is that human beings resent being forced to do things against their will. This contrary streak leads them to resist tax collectors. The result is that in stead of a smooth hum of money pouring effortlessly into the Treasury, taxation turns into a costly, and often tragic, guerrilla war. To compel the population to conform to its 126 THE FREEMAN • MARCH 1994 demands, the government has to operate a burdensome enforcement program. The reader might find it instructive to try to guess how many levies the IRS issues each year. A levy is an order directed to entities like banks and employers forcing them to send the taxpayer's money to the govemment-a routine IRS seizure of prop erty without due process of law. For the in dividuals involved, a levy is a personal catas trophe. Funds have been seized, credit de stroyed, financialplans and dreams wrecked, and businesses shuttered. How many of these devastating enforcement episodes are necessary to make the tax system work?

Raised in a culture of spending that fosters the illusion of government as a beneficent cornucopia, Americans suppose this num ber is trivially small. In fact, it is a national scandal. For 1992, the IRS reports issuing 3,253,000 levies. Because of double-count ing and IRS clerical errors, this figure over states the number of human beings affected; a correction for these distortions reduces this figure by half, to about 1,600,000 people affected. This is still a sizeable chunk of humanity, more than the entire population of Nebraska. This avalanche of levies constitutes only a small fraction of all enforcement actions. To keep the money flowing into the Trea sury, the IRS also issues liens, which freeze taxpayer assets (1.5 million); sends out un derreporter notices, which allege taxpayer underpayment of taxes (3.8 million), and non-filing notices, which allege a taxpayer failure to file a tax return (1.5 million); conducts personal audits of taxpayers (1.0 million), and mail audits and service center corrections (0.5 million); and imposes some nine million filingand payment penalties. In addition, it pursues about 6,000 criminal prosecutions, trying to jail people for failing to adhere to the tax code.

Naturally, the human beings caught in these snares struggle, expending enormous time and energy trying to keep their funds and prove the IRS wrong. In the under reporter program, for example (where over half of the IRS accusations turn out· to be wrong), I have estimated that Americans spend 30 millionhours yearly reacting to the worrisome brown envelopes: studying the notices, examining tax law, reviewing tax data, discussing their cases with friends and advisors, and composing letters of protest. The level of tax litigation-the audit ap peals, court cases, and tax rulings-is run ning at 195,000 cases a year. According to my calculations, the mone tary cost to the American public of dealing with IRS enforcement actions in 1985 was over $13 billion, a figure three times the entire budgetary cost of the IRS. This financial cost doesn't begin to mea sure the moral and emotional burdens of a system based on putting a gun to everyone's head. The anxiety, stress, and frustration generated by IRS tax enforcement represent a social blight as serious as the danger of cancer or the tragedy of divorce. That the money is being raised in a good cause does not lessen the human pain. Consider the 1988 suicide of Alex Council. The victim of an erroneous IRS lien that ruined him finan cially, he shot himself and left a suicide note instructing his wife to use his insurance money to pursue the legal case against the IRS-which she eventually won.

The Cost of Tax Avoidance and Evasion To function efficiently, a tax system needs citizen cooperation.· Unfortunately, by re lyingon force, the tax system undermines its claim to taxpayer goodwill. Instead of hap pily cooperating with tax collectors, citizens scheme to confound them. In the United States, high tax rates and the impossibly complex tax code have made tax evasion and avoidance a major industry. Unfortunately, it is a completely unproduc tive industry, feeding no one and housing no one. It is merely the wasteful struggling of human beings trying to avoid the·exactions of government. Some citizens avoid taxes by taking their economic activity underground. By my es timate, there are at least 2 million people with significant potential tax liabilities who are driven underground by the tax system 244,300,000.00 350,400,000.00 19,700,000.00 29,600,000.00 6,100,000.00 $1,650,100,000.00 INSIDE THE FEDERAL HURTING MACHINE 127 What Does a $1 Billion Federal Program Cost?

The budgeted price tag: $1,000,000,000.00 Plus, additional tax system burdens: Compliance costs (24.43%) The cost of forgone production (35.040/0) Enforcement costs (1.970/0) The cost of avoidance and evasion (2.96%) The budgetary cost of the IRS (0.610/0) TRUE TOTAL COST: Source:adaptedfrom James L. Payne, CostlyReturns;The Burdensof the U.S. Tax System(leS Press, 1993), p. 150. (another 2 millionhave gone underground as a result of immigration and drug laws). In attempting to avoid taxation, they have reduced their own productivity and there fore that of the entire economy. Having to stay out of sight severely curtails their ability to use the banking system, to adver tise, and to hire more workers. Other tax avoiders turn to legal, or ques tionably legal, investment tax shelters. Again, a social waste is incurred as they tie their resources up in unproductive invest ments and pay shelter promoters for setting up and servicing the tax avoidance device.

To avoid estate taxes, millionsof people hire lawyers to devise and administer estate tax shelters. Highly skilled legal professionals work week in and week out drawing up grantor retained income trusts, generation skipping trusts, and so on. Another class of skilled professionals is busy exploiting the tax avoidance potential of foreign tax ha vens, while yet another group manages the massive paperwork that makes possible re tirement tax shelters. All told, by my esti mate, the nation wasted some $19 billion in tax avoidance and evasion activities in 1985-a figure that has probably about dou bled since then. Adding Up the Costs When all the burdens are added together, what is the monetary cost of the U.S. federal tax system? According to my calculations, the answer is that, in 1985, the burden was $363 billion. In dynamic terms, the burden is 65 percent of the taxes collected. This figure represents the only attempt anyone has made to estimate the cost of the tax system. Studies have been made of some of the sub-costs, but no one else has been prompted to add the numbers together to calculate a total cost.

The absence of other estimates is remark able because, as we noted at the beginning, it is impossible to make rational decisions about government spending programs un less the costs of raising the money are factored in. Economists should have no ticed, for example, that their theories about the social benefit of government subsidies are meaningless unless tax system costs are known. It's like trying to calculate whether a plane can fly without knowing its weight. One excuse that policy makers might give for not considering the costs of taxation is the assumption that these costs are fixed. In order to raise the first dollar of taxes, this argument would go, the entire $363 billion burden noted above is incurred. Therefore additional tax dollars raised for additional spending programs entail no further costs. The costs in the tax system don't work this way, however. The majority of the costs not only increase with the tax rate, but they do so exponentially. The disincentive cost, as it is calculated by economists, is tied to the square of the tax rate: double the money you try to raise and you quadruple the cost in lost production, people thrown out of work, and so on. Most of the costs associ ated with enforcement, evasion, and avoid ance also go up exponentially with the tax rate. As more money is at stake, it pays taxpayers to work harder to keep tax col lectors from getting it. Even compliance costs are variable. When taxes are raised to 128 THE FREEMAN • MARCH 1994 pay for more spending programs, tax avoid ance goes up, which in tum prompts the tax authority to issue more regulations to pre vent it. The result is a more complex tax system and higher compliance costs.

The overall picture, then, is that tax system costs increase along with the level of taxes. The 65-percent figure noted above is a marginal cost figure: if taxes are raised another $100 million to pay for another spending program, an additional $65 million cost will be imposed on the economy. We return to our point: why have policy makers ignored these costs? The answer appears to be the powerful social conven tion against weighing the costs of taxation. Legislators and their publics want to believe in government as a helping machine, and it spoils the illusion to be told that it is, at the same time, a hurting machine. Consider how programs to create jobs are discussed in Washington. Common sense tells us that any government spending pro gram designed to create jobs must also cause unemployment. After all, the taxes imposed to pay for it drain money away from inves tors who would have opened new busi nesses, and from consumers who would have employed workers through their pur chases. When we add to this common sense analysis our knowledge of the costs of the tax system, it becomes clear that a jobs creation program could well destroy more jobs than it creates. Therefore, anyone pro posing ajobs-creation program ought to give Congress two figures:the number ofjobs the program hopes to create, and the number of jobs the taxation to pay for the program is expected to destroy.

This, of course, is never done, because telling the whole truth would make the project look foolish. Journalists would ques tion the sanity of a president who proposed to create jobs by destroying them. Affordable Health Care? Take another issue: government provi sion of medical care. The responsible policy maker would have to point out that government is not a something-for-nothing ma chine. It cannot pay for health care unless it first takes money away from the citizens it wants to help. Furthermore, it can never return to them the full value of their contri butions. The administrative overhead-the bureaucracy, the paperwork, the overcharg ing, the fraud, the disputes over bene fits-are bound to consume a large fraction of resources devoted to the spending pro gram, probably around half of the funds. In addition to this waste, there is the 65 percent cost of raising the money through the tax system.

Hence, the overall arithmetic for a gov ernment health care system would look something like this: To raise $100in taxes to fund the system costs an additional $65, and then of that $100, government adminis tration and waste consume about half, or $50. So for an initial $165 total burden, the citizen willget $50worth of medical care out of the system. This is the bedrock statistic that Washington's health care analysts should be telling the American people: A government health care system is going to cost the average person three times as much as paying medical bills out of his own pocket. Alas, no one mentions any such figure. Legislators, eager to appear well-inten tioned, ignore the down side of their pro posals. That makes as much sense as count ing benefits but never costs. Less excuse can be found for the silence of the technical specialists, the thousands of experts work ing for Washington's alphabet soup of re search agencies, the OMB, the GAO, the CBO, and so on. These professionals are paid huge sums of taxpayer money to find out about policies and inform the country about their true costs. Yet no one in any of these agencies has compiled any estimate of the overhead cost of tax-and-spend pro grams.

Ignoring the costs of taxation has gone on long enough. It's time to put aside our childish faith in government and take a frank, careful look at the human costs of its optimistic endeavors. D THEFREEMAN IDEASON LIBERTY GOVERNMENT REDISTRIBUTION IMPOVERISHES THE POOR by Dwight R. Lee O nly the most ideologically blinded con tinue to argue that socialism can out perform capitalism in the production of wealth. Yet the assertion that government programs are required to reduce the income inequality generated by capitalism is widely accepted as revealed truth. Market compe tition motivates productive activity by threatening with poverty those who use resources unwisely, and carrying out this threat without mercy. So, it is argued, in the absence of compassionate government transfer programs, a large percentage of the population would be left behind, impover ished, without hope, and made all the more miserable by the audacious wealth of their more successful neighbors.