Complexity and the Tax Gap

Comments for the Record

Complexity and the Tax Gap:

Making Tax Compliance Easier and Collecting What’s Due

United States Senate Committee on Finance

Tuesday, June 28, 2011, 10:00 AM

215 Dirksen Senate Office Building

Submitted by:

Michael Bindner

Center for Fiscal Equity

Chairman Baucus and Ranking Member Hatch, thank you for this opportunity to provide comments to the Committee. We will leave it to other expert witnesses to describe how such options as the Value Added Tax (VAT) and a VAT-like Net Business Receipts Tax (NBRT) can be useful in providing incentives to accurately report taxes at every stage of the production process.

It is likely that for many, this unavoidability of payment is one of the reasons such taxes are opposed. These features are also one of the main reasons that these options are superior to the so-called Fair Tax, which will likely increase the tax gap because many items which are in fact purchased for end use will be accounted for as wholesale in order to avoid taxation. If taxes are paid at each stage of production, this problem does not exist. Of course, analysis of how VAT systems are actually implemented suggests that the VAT is no panacea in stemming tax avoidance, especially if multiple rates and loopholes are present in the system.

At the Center for Fiscal Equity, we marvel at strength of the myth that if only the Tax Gap were eliminated, all would be right with the world of federal finance. Indeed, part of the mythos behind the Fair Tax is that finally prostitutes and drug dealers would be paying their fair share of taxes under this plan.

This assertion is patently false and misunderstands the relationship between consumption taxes and income taxes. Income taxes are essentially a hidden consumption tax, especially when one is purchasing from a business with federal and state tax identification numbers. Most employees in these cases never see that portion of their earnings which go to pay Federal Income, State Income, FICA, and Hospital Insurance payroll taxes. These monies essentially go from sales or other revenues right to federal and state governments, along with any sales taxes collected.

Unless prostitutes and drug dealers obtain tax ID numbers and report taxes as businesses under a Fair Tax, a VAT or a VAT-like NBRT, their payment of such taxes as consumers will likely be no different than their current indirect payment of the income and payroll taxes of those from whom they purchase goods and services.

Waiters, bartenders and the self-employed are also no more likely to pay more under tax reforms designed to eliminate the tax gap. Rather, these reforms can best close the tax gap by simply trying to collect taxes from them if their income falls under a certain threshold. This allows the government to set appropriate rates without the expectation that better enforcement might lead to a balanced budget.

There one more issue we would like to put on the record in this debate, however: the question of who is an employee and who is an independent contractor. Waiters are often considered semi-independents, especially when tips are left in cash rather than added to the bill and paid with credit cards. In many more advanced companies, part time contractors and even essentially full time employees are hired as contractors or independent brokers, even though all of their efforts are dedicated to a single wholesaler or customer. The insurance and home cosmetic industries are prime examples of workers who are essentially employees operating and reporting as if they were independents. This is done to minimize benefits paid and to force the burden of tax reporting onto these employees, thus fueling the problem of low compliance.

Limits on revenue could be used to essentially keep these vendors outside the tax collection system. It could be called an Avon Lady exemption. In a VAT system, enacting such an exemption would lead to little tax loss, as the entire supply chain leading up to these vendors would still pay tax. This would not be the case under a Fair Tax system. Indeed, in a Fair Tax system, Congress would likely be required to consider such vendors employees of the supplying firm in order to realize all potential tax revenue from these industries.

The Center has outlined the NBRT to this Committee and its companion in the other body on more than one occasion. One of the strengths of this tax is that it can be used to preserve both the health insurance exclusion and an expanded child tax credit – and potentially could lead to a wide variety of tax expenditures designed to shift the funding of social services from the public sector to the private sector. This strength cannot be realized, however, when the sales force or consultants are considered outside vendors, nor would leaving such individuals outside the franchising company eliminate the need for them to file taxes as business owners. To the extent that ease of compliance is a goal of tax reform, reconsidering the issue of who is considered an employee must take place.

Thank you for this opportunity to provide comments to the Committee.