| CRITERIA USED IN THE SELECTION OF A TAX STRUCTURE | PROPERTY TAXES | WHO
PAYS THE U.S. INCOME TAX? | OTHER TAX BASES | PROPOSED U.S. TAXES | TAX
AVOIDANCE VS.
EVASION | TAX ADMINISTRATION |
CRITERIA USED IN THE SELECTION OF A TAX STRUCTURE
1.
In the eighteenth century, Adam Smith identified the following canons of taxation , which still should be considered when evaluating a particular tax structure.
1

Equality.
Each taxpayer enjoys fair or equitable treatment by paying taxes in proportion to his or her income level. Ability to pay a tax is the measure of how equitably a tax is distributed among taxpayers.

Convenience.
Administrative simplicity has long been valued in formulating tax policy. If a tax is easily assessed and collected and its administrative costs are low, it should be favored. An advantage of the withholding (pay-as-you-go) system is its convenience for taxpayers.

Certainty.
A tax structure is good if the taxpayer can readily predict when, where, and how a tax will be levied. Individuals and businesses need to know the likely tax consequences of a particular type of transaction.

Economy.
A good tax system involves only nominal collection costs by the government and minimal compliance costs on the part of the taxpayer. Although the government’s cost of collecting Federal taxes amounts to less than 1 percent of the revenue collected, the complexity of our current tax structure imposes substantial taxpayer compliance costs.
By these canons, the Federal income tax is a contentious product. Equality is present as long as one accepts ability to pay as an ingredient of this component. Convenience exists due to a heavy reliance on pay-as-you-go procedures. Certainty probably generates the greatest controversy. In one sense, certainty is present since a mass of administrative and judicial guidelines exists to aid in interpreting the tax law. In another sense, however, certainty does not exist since many questions remain unanswered and frequent changes in the tax law by Congress lessen stability.
Economy is present if only the collection procedure of the IRS is considered. Economy is not present, however, if one focuses instead on taxpayer compliance efforts and costs.
In 2001, the American Institute of Certified Public Accountants (AICPA) issued suggestions on
Federal tax policy. Titled Guiding Principles of Good Tax Policy: A Framework for Evaluating Tax
Proposals , the monograph sets forth 10 tax principles that are commonly used as indicators of desirable tax policy.
The first four principles are adapted from Adam Smith’s The Wealth of Nations . The other six are summarized below. The full text of the monograph is available at www.aicpa.org
.

The tax system should be simple.


The tax should be neutral in terms of its effect on business decisions.

The tax system should not reduce economic growth and efficiency.

The tax should be clear and readily understood, so that taxpayers know about it and when it applies.

The tax should be structured so as to minimize noncompliance.

The tax system should enable the government to predict the amount and timing of revenue production.
The Tax Foundation has issued the following statement about tax systems that promote jobs and economic growth. See especially the discussion of state business tax climates at www.taxfoundation.org
. Here is a paraphrase of the statement.
The ideal tax system, at the local, state, or federal level, is simple, transparent, stable, neutral to business activity, and pro-growth. Individuals and businesses would spend a minimum amount of resources and time to comply with the tax system, understand the true costs of the system, base their economic decisions solely on the merits of the underlying transactions, without regard to tax implications, and not have the tax system impede their growth and prosperity.
Tax Foundation guidelines also call for taxes and law changes that are not applied retroactively, so that taxpayers can rely on the law as it stands when contracts are signed and transactions are completed.
The Tax Foundation generally calls for taxes that show broad bases and low rates. This means that lawmakers should avoid adopting targeted deductions, credits, and exclusions. With restrictions as to the use of tax preferences, tax rates can stay low, revenue collections will be stable from year to year, and the U.S. economy can compete well globally with other countries.
PROPERTY TAXES
2. Unlike the ad valorem tax on personalty, the tax on realty is difficult to avoid. Because real estate is impossible to hide, a high degree of taxpayer compliance is not surprising. The only avoidance possibility that generally is available is associated with the assessed value of the property. For this reason, the assessed value of the property —particularly, a value that is redetermined upward —may be subject to controversy and litigation.
The history of the ad valorem tax on realty has been marked by inconsistent application due to a lack of competent tax administration and definitive, standardized guidelines for assessment procedures. In recent years, however, some significant improvements have occurred. Some jurisdictions, for example, have computerized their reassessment procedures so that they immediately affect all property located within the jurisdiction.
Several jurisdictions provide homeowners with a measure of protection from increased property taxes by “freezing” existing assessments and limiting future upward adjustments. Such restrictions on reassessments, however, do not carry over to the new owner when the property is sold. Thus, such measures tend to lock in ownership and restrict the mobility of those who might otherwise change residences.
WHO PAYS THE U.S. INCOME TAX?
3.
There are plenty of commentators nowadays talking about how to “fix” the Federal income tax.
Think tanks, op-ed columnists, and presidential hopefuls have released sometimes-elaborate plans for how the tax law should work.

The Tax Foundation has issued a series of papers detailing some of the data that tax reformers should consider. Here are some of the highlights of their findings, most of which simply analyze publicly available IRS and Treasury data. For the full text of the papers, go to www.taxfoundation.org
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By most estimates, about ten percent of all potential taxpayers do not even file a tax return, because of insufficient income. These parties typically include the elderly, the young, and those in poverty. And another one-third of taxpayers (47 million of them) files a return and has no tax due. This means that all withholdings are returned to the taxpayer
(ideally the taxpayer would have arranged with the employer to have zero withholding to begin with), and perhaps an earned income credit and refundable child tax credit attaches so as to pay more than the withheld amount to the filer. The Tax Foundation refers to these individuals as “non-payers” as opposed to the “non-filers.” Non-payers typically achieve such status by applying the child tax credit and various education deductions and credits. Steady increases in the standard deduction and personal exemptions, and the statutory relief from prior so-called marriage penalties create other non-payers. Here are some historical data about non-payers.
Tax Year
1950
1970
1978
1984
2010
Tax Filers With a Zero Federal Income Tax
Liability (%)
28
16
26
18
41

Over half of the non-payers claim a refundable tax credit. In 2010, refundable earned income credits totaled about $52.5 billion, and the refundable portion of the child tax credit accounted for about $28 billion of payments. Because of the use of these refundable credits, the incidence of the Federal income tax burden is very low or negative for low-income taxpayers. Tax credits (probably purposely) decrease an already low tax burden at lower income levels, and the result is a redistribution of the tax burden to upper-income taxpayers.

IRS and Census data find that current non-payers tend to be: o Low income (97% earn < $40,000 per year) o Young (36% are < age 25; 56% are < age 35) o Women and unmarried (54% are single women or female-headed households)
Estimated Filing Status of Federal Income Tax Non-Payers
Filing Status % in Filing Status
That Are Non-Payers
% of All Non-Payers
Single
Married, Joint Return
Married, Separate Return
Head of Household
33.1
21.5
21.6
65.7
42.2
29.8
1.2
26.6


Combined, non-payers total about 58.6 million tax returns annually. Because of the use of joint returns, the Tax Foundation estimates that non-filers and non-payers represent about 44 percent of the total U.S. population who are “outside of the Federal income tax system” (i.e., they paid no income tax to the Federal government at all). This may represent the will of the voters, and it may be good government policy as to taxes, poverty, and employment. But is it wise in a civic-mindedness sense to have so many individuals making no contribution to the operations of the government? How about a
“minimum income tax” so that all citizens are required to contribute some amount to support government operations?
It is true that the non-filers and non-payers do contribute to the Federal government through payroll, alcohol, and gasoline taxes and to state and local governments through sales/use and property taxes on housing. But most voters have no idea how skewed is the current distribution of the Federal tax burden. It is important to disseminate this information on tax incidence, and also to measure the effects of low or negative contributions to the system on one’s attitude toward government and fellow citizens. The Tax Foundation paper makes the same point.
While some may applaud the fact that millions of low- and middle-income families pay no income taxes, there is a threat to the fabric of our democracy when so many Americans are not only disconnected from the costs of government but are net consumers of government benefits. The conditions are ripe for social conflict if these voters begin to demand more government benefits because they know others will bear the costs.
OTHER TAX BASES
4.
Over time, countries have levied taxes of types that seem odd to us today, but they were justified at the time by the needs of the pertinent government, economy, or peoples.
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To increase the domestic population, Argentina assessed a special tax on unmarried men between ages 21 and 75. The tax was waived if proof was shown that the bachelor had been turned down three times during the year in his proposals for marriage.
Germany and France applied higher tax rates to unmarried men. Illinois applied a tax on bachelors between ages 32 and 65, with the taxes collected earmarked to fund an “Old
Maids ’ Home.”
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A tax on the manufacture of corsets was debated by the U.S. Senate when silk was in short supply. Supporters wished to curb the racy nature of the undergarments, but others stated that the tax would discriminate against women. Similar taxes were levied in France and England, but the English tax was repealed in 1953 with an argument that the goods promoted women’s health, and not just their vanity.

Some countries assess an “entry tax,” payable when an immigrant crosses the border.
The tax can be seen as a way to track the location of the visitor, or to limit the number of immigrants who relocate to the taxing country.

To limit obesity, several U.S. states tax candy, fatty snack foods, and sugared soft drinks.
PROPOSED U.S. TAXES
5.
Considerable dissatisfaction with the U.S. Federal income tax has led to several recent proposals that, to say the least, are rather drastic in nature. One proposal would retain the income tax but with substantial change. Two other proposals would replace the Federal income tax with an entirely different system of taxation .

The Flat Tax
One proposal is for a flat tax that would replace the current graduated income tax with a single rate of 17 percent. Large personal exemptions (e.g., approximately $30,000 for a family of four) would allow many low- and middle-income taxpayers to pay no tax. All other deductions would be eliminated, and no tax would be imposed on income from investments.
Various other versions of the flat tax have been suggested that would retain selected deductions
(e.g., interest on home mortgages and charitable contributions) and not exclude all investment income from taxation.
The major advantage of the flat tax may be its simplicity. Everyone agrees that the current
Federal income tax is unbelievably complex. Consequently, compliance costs are disproportionately high. Proponents of the flat tax further believe that simplifying the income tax will significantly re duce the annual $300 billion “tax gap” (i.e., the difference between the amount of taxes that should be paid and what is actually paid ).
Political considerations are a major obstacle to the enactment of a flat tax in its pure form. Special interest groups, such as charitable organizations and mortgage companies, are not apt to be complacent over the elimination of a tax deduction that benefits their industry. In addition, there is uncertainty as to the economic effects of the tax.
It is interesting to not e that Russia’s attempt at a progressive income tax was somewhat disastrous. Not only did high rates drive capital out of the country, but failure to report income was rampant. The income tax was repealed and replaced with a 13 percent flat tax. To date, the flat tax has worked quite well. Several Baltic states (Estonia, Latvia, and Lithuania) have followed
Russia’s example. Romania, Albania, Slovakia, Georgia, Ukraine, and Serbia have also adopted a flat tax.
Value Added Tax
Under a value added tax (VAT), a business pays the tax rate (usually between 5 and 20 percent) on the materials and services incurred to manufacture its products. In effect, a VAT taxes the incremental value that is produced as goods move through the production process to the m arketplace. Some observers describe the VAT as a “layered sales tax.”
In spite of its extensive use by other countries (including Canada), the adoption of a VAT by the
United States appears doubtful.
TAX AVOIDANCE VS. EVASION
6.
Some observers find it difficult to grasp the difference between tax planning/avoidance and tax cheating/evasion, believing that tax professionals deal in “tax schemes” and “loopholes” and commit unethical acts on behalf of their clients.
The classic quote by Learned Hand on p. 1-20 in the text is a good starting point at distinguishing between avoidance and evasion. Or how about this Freakonomics blog about tax cheating to start the discussion? And this quote from an essay by Justice Louis Brandeis, Thoughts on Legitimate
Tax Awareness and Avoidance, with some minor edits.
I live in Alexandria, Virginia. Near the Supreme Court chambers is a toll bridge across the Potomac. When in a rush, I pay the dollar toll and get home early.
However, I usually drive outside the downtown section of the city and cross the
Potomac on a free bridge.

This free bridge was placed outside the Washington DC area to serve a useful social service, to help alleviate congestion during rush hour.
If I went over the toll bridge and through the barrier without paying the toll, I would be committing tax evasion.
If, however, I drive the extra mile to the free bridge outside the city, I am using a legitimate, logical, and suitable method of tax avoidance, and I am performing a good deed for society by doing so.
For my tax evasion, I should be punished; for my tax avoidance, I should be commended.
The tragedy of life today is that so few people know that the free bridge even exists.
TAX ADMINISTRATION
7.
The responsibility for administering the Federal tax laws rests with the Treasury Department.
Administratively, the IRS is part of the Department of the Treasury and is responsible for enforcing the tax laws. The Commissioner of Internal Revenue is appointed by the President and is responsible for establishing policy and supervising the activities of the entire IRS organization.
The Audit Process
Selection of Returns for Audit.
Due to budgetary limitations, only a small minority of tax returns are audited. The IRS audits only about 1 percent of all individual income tax returns (about one in every 145 returns filed). The number of individual income tax returns being audited has increased significantly over the past five years.
The IRS utilizes mathematical formulas and statistical sampling techniques to select tax returns that are most likely to contain errors and to yield substantial amounts of additional tax revenues upon audit. The mathematical formula yields a regression function that is called a Discriminant
Index Formula (DIF) score. It is the DIF score given to a particular return that may lead to its selection for audit.
To update the DIF components, the IRS selects a cross section of returns, which are subject to various degrees of inspection (i.e., information return verification, correspondence, and face-toface audits with filers). The results of these audits highlight areas of taxpayer noncompliance and enable the IRS to use its auditors more productively. In recent years, IRS audits have resulted in an increasing number of ‘‘no change’’ results (see below). This indicates that the IRS is not always choosing the right returns to audit (i.e., the ones with errors).
Though the IRS does not openly disclose all of its audit selection techniques, the following observations may be made concerning the probability of selection for audit.

Certain groups of taxpayers are subject to audit much more frequently than others. These groups include individuals with large amounts of gross income, self-employed individuals with substantial business income and deductions, and taxpayers with prior tax deficiencies. Also vulnerable are cash businesses (e.g., cafes and small service businesses) where the potential for tax avoidance is high.

Example: Jack owns and operates a liquor store on a cash-and-carry basis. Since all of Jack’s sales are for cash, he might well be a prime candidate for an audit by the IRS. Cash transactions are easier to conceal than those made on credit.

If information returns (e.g., Form 1099, Form W –2) are not in substantial agreement with reported income, an audit can be anticipated.
 If an individual’s itemized deductions are in excess of norms established for various income levels, the probability of an audit is increased.
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Filing of a refund claim by the taxpayer may prompt an audit of the return.
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Information obtained from other sources (e.g., informants, news items) may lead to an audit. Recently, for example, the IRS advised its agents by Internet to be on the alert for newspaper accounts of large civil court judgments. The advice was based on the assumption that many successful plaintiffs were not reporting as income the punitive damages portion of awards, which is taxable.
The tax law permits the IRS to pay rewards to persons who provide information that leads to the detection and punishment of those who violate the tax laws. The rewards may not exceed 15 percent of the taxes, fines, and penalties recovered as a result of such information.
Example: After 15 years of service, Rita is discharged by her employer, Dr. Smith. Shortly thereafter, the IRS receives an anonymous letter stating that Dr. Smith keeps two separate sets of books, one of which substantially understates cash receipts.
Example: During a divorce proceeding, it is revealed that Leo, a public official, kept large amounts of cash in a shoebox at home. This information is widely disseminated by the news media and comes to the attention of the IRS. Needless to say, the IRS would be interested in knowing whether these funds originated from a taxable source and, if so, whether they were reported on Leo’s income tax returns.
Types of Audits.
Once a return is selected for audit, the taxpayer is notified. If the issue involved is minor, the matter often can be resolved simply by correspondence (a correspondence audit) between the IRS and the taxpayer.
Example: During 2014, Janet received dividend income from Green Corporation. In early 2015,
Green reported the payment on Form 1099 –DIV (an information return for reporting dividend payments), the original being sent to the IRS and a copy to Janet. When preparing her income tax return for 2014, Janet apparently overlooked this particular Form 1099 –DIV and failed to include the dividend on Schedule B, Interest and Dividend Income, of Form 1040. In 2016, the
IRS sends a notice to Janet calling her attention to the omission and requesting a remittance for additional tax, interest, and penalty. Janet promptly mails a check to the IRS for the requested amount, and the matter is closed.
Other examinations are generally classified as either office audits or field audits . An office audit usually is restricted in scope and is conducted in the facilities of the IRS. In contrast, a field audit involves an examination of numerous items reported on the return and is conducted on the p remises of the taxpayer or the taxpayer’s representative.
Upon the conclusion of the audit, the examining agent issues a Revenue Agent’s Report (RAR) that summarizes the findings. The RAR will result in a refund (the tax was overpaid), a deficiency
(the tax was underpaid), or a no change (the tax was correct) finding. If, during the course of an audit, a special agent accompanies (or takes over from) the regular auditor, this means the IRS suspects fraud. If the matter has progressed to an investigation for fraud, the taxpayer should retain competent counsel.

Notes:
1 The Wealth of Nations , Book V, Chapter II, Part II (Dutton, New York: 1910).
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