Wednesday, January 26, 2011

Zelenak: Complex Tax Legislation in the TurboTax Era

Here is the abstract of Prof. Zelenak's fascinating article on Complex Tax Legislation in the TurboTax Era.

When tax returns were prepared with pencil and paper—in an era now gone forever—Congress did not impose income tax provisions of great computational complexity on large numbers of taxpayers, in the belief that it was unreasonable to require average taxpayers (or their paid preparers) to struggle with computationally complex provisions. As return preparation software gradually replaced the pencil in recent decades, the complexity constraint weakened and eventually disappeared. Congress has responded by imposing unprecedented computational complexity on large numbers of taxpayers—primarily through the expanded scope of the alternative minimum tax and the proliferation of phase outs of credits, deductions, and exclusions. This response would not be problematic, if the only objection to computational complexity were the difficulty of performing the calculations—a difficulty overcome by the widespread adoption of software. Unfortunately, computationally complex provisions generally constitute bad tax policy, even apart from computational concerns. For taxpayers faced with a welter of computationally complex provisions, the income tax is a black box, the inner workings of which are beyond their comprehension. This undermines both the political legitimacy of the tax system and the ability of taxpayers to engage in informed tax planning. In response to the demise of the complexity constraint, argues this Essay, Congress should develop a self-imposed constraint against the enactment (or survival) of computationally complex provisions of widespread applicability.

The entire text is available here.

If you need more inducement, check out this fascinating excerpt:

The earliest tax return preparation software was developed by a handful of small companies in the late 1970s and early 1980s. The early adopters were overwhelmingly paid preparers, rather than taxpayers preparing their own returns. For example, in 1982 Jackson Hewitt—now the nation’s second largest tax preparation service, but then just a small business in Virginia—took the radical step of using self-developed software to prepare all its customers’ returns.

By 1987, about a quarter of all paid preparer returns were being produced on computers. Newspaper and magazine stories about the possibility of self-preparers using software did not appear until 1983. Data do not exist on the extent of software use by self preparers in the 1980s, but according to a leading expert on the growth of the use of return preparation software “[i]t is reasonable to infer that very few self-preparers used software” even towards the end of the decade.

The greatest growth in the use of return preparation software occurred from the mid-1980s to the mid-1990s. Only 13% of all individual returns had been prepared on computers in 1987, but 67% of all returns for tax year 1997 were computer-prepared.

This included 87% of paid preparer returns and 45% of self-prepared returns.

Much of the growth in software use during this period was attributable to the pencil-to-software transition by industry giant H&R Block. Block did not use return preparation software at all until 1990, and did not complete the transition to software until 1993.

By tax year 2006 (the most recent year for which data are available), 89% of all individual returns were prepared on computers. This included 98% of paid preparer returns and 71% of self-prepared returns. In light of the seemingly inexorable trend, it is very likely that the data for returns for tax year 2008, when they become available, will indicate that fewer than one return in ten is now being prepared using pencil and paper.

Although our tax system is complex, many people have very simple tax returns. It doesn't always take a rocket scientist or computer software to prepare some tax returns. It would be good if more folks at least attempted a rough draft of their tax returns with paper and pencil as a "reality check" BEFORE they start crunching the numbers.

Or folks could even use a simple self-designed computer spreadsheet. That is what I used in the 1980s before commercial tax software was available.

Many people might be pleasantly surprised that their taxes are actually more understandable than they previously realized. And for those who discover they aren't in that happy state, that their taxes are truly byzantine--they should contact their Congressional representatives and read them the riot act.

It shouldn't take a PhD in math from Berkeley to understand your income taxes, nor should it require mysterious and opaque "black box" software.

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