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The Hidden High Costs of Federal Income Taxes

Updated on April 19, 2014

Tax Season is When Many Get their Money Back from the Federal Government

Every year as April 15th approaches, last minute tax filers rush to complete and mail their Federal Income taxes.

While an increasing minority end up sending money to the government with their tax returns, most wage earners are recipients of a refund. This is because the Current Tax Payment Act of 1943, requires that employers deduct a portion of each wage earning employee’s estimated income tax liability from their paychecks. The money is then forwarded to the U.S. Treasury as it is collected.

Along with being required to have part of their pay diverted to the U.S. Treasury as it is earned, the government is also allowed to assess a financial penalty on people whose tax liability exceeds their withholding by more than a specified amount. Over withholding is thus the choice of many.

IRS Form 1040 for Individuals

IRS Tax Form 1040 for Individuals Seeking to Itemize Federal Tax Deductions
IRS Tax Form 1040 for Individuals Seeking to Itemize Federal Tax Deductions

Income tax withholding has a triple benefit for the Federal government.

  • First, instead of having to wait for its funds, the government is able to enjoy a steady stream of revenue throughout the year.

  • Second, the government gets the use of taxpayer funds, interest free, for up to a year before the taxes are actually due. And, because of over withholding, the government gets to borrow and use these additional funds interest free as well.

  • Finally, since the tax funds are siphoned out of their paychecks wage earners rarely notice or feel the pain of paying taxes. It is hard to get upset over the loss of money that one never sees. Also, because of over withholding, the receipt of a refund check during tax season makes people feel like they are getting something for their taxes.

Hidden Costs Associated With Paying Income Taxes

In addition to the loss of income due to having to pay taxes and the loss of potential interest income by having funds for their estimated tax liability taken and used, interest free, by the government in advance of the tax due date, there are other costs to both individuals and the nation as a whole due to the present income tax system.

First and foremost is the cost, in terms of time and money, taxpayers find themselves having to pay in order to comply with today’s complex Federal Income Tax.

Federal Tax Law is Growing Faster than Weeds in Spring

The law governing the Federal Income Tax is known as Title 26 of the U.S. Code. The U.S. Code is a compilation of all federal laws currently in effect. At last count, in 2012, the U.S. Code was over 200,000 pages and growing.

Title 26, the section relating to income taxes is currently estimated to be just under 74,000 pages and increasing at the rate of about 346 pages per year.

Since World War II, Title 26 has grown at the rate of about 3,076 pages per year and the decline in page growth in the last couple of years to about 346 is due to the gridlock in Congress. Most of the credit for this goes to Senate Majority Leader Harry Reid who has succeeded in preventing the Senate from voting on most bills that come before it.

Most of the 300 to 3,000 pages of new tax legislation every year comes in the form of additions that are quietly inserted, by anonymous Congressional staffers on behalf of special interest supporters, into other pending legislation that has nothing to do with taxes. Thus, the tax code expands silently with few voters being aware of the steady stream of additions.

According to IRS Taxpayers Collectively Spend 7.6 BILLION Hours Complying With Tax Law

According to the IRS’s Taxpayer Advocate Service's 2008 Annual Report to Congress, Vol I, individuals and businesses spend about 7.6 Billion hours per year complying with the documentation and filing requirements associated with paying federal income taxes.

What a 3.8 MILLION Worker Industry Would Look Like

  • According to the 2010 Census the total population of the U.S. (the 50 states and District of Columbia) came to 308.8 million people making the 3.8 million full time workers needed for the tax compliance industry 1.2% of the entire U.S. population.

  • Looking just at the working age population, those 18 to 45 years, the 2010 Census came up with 194.3 million people which causes the 3.8 million needed for the fictitious tax compliance industry to jump to nearly 2% (1.9557%). Of course the 18 to 64 age group includes a number of people who, for various reasons, are not employed.

  • The U.S.Dept of Labor estimates that, as of March 2014, the total U.S. labor force (those working or actively looking for work) amounted to 156,227 million of which 145,742 million were actually employed. This makes the 3.8 million workers needed for tax compliance 2.4% of the labor force and 2.6% of those currently employed

  • The 3.8 million full time workers needed for individual and corporate tax compliance is greater than the 2010 population of 22 of the 50 states. It is also more than double the population of each of the fourteen states with the lowest population.

  • If a new city was created to house only those needed (workers only, no families) to perform the compliance work for individual and corporate tax filing, that city would be the third largest in the United States.

This 7.6 billion hours just refers to the estimated total time the American public spends doing what is required to simply comply with the law in filing their taxes.

It does not include the millions of additional hours spent by those having to respond to IRS inquiries and notices or to tax audits AFTER they have filed their taxes.

The report further states that, if tax compliance was an industry, the 7.6 billion hours would translate into 3.8 million full time workers making it one of the largest industries in the U.S.

However, tax compliance is NOT a separate industry as the 3.8 million worker figure refers to how many full time (40 hours per week) would be needed to do the work now done by taxpaying individuals and organizations.

This number would be higher if the IRS had used ObamaCare’s new definition of 30 hours per week as constituting full time work.

Many of the 7.6 billion hours cited above refer to unpaid, government mandated work by private citizens outside of their paid work hours. This despite the Constitution’s (Thirteenth Amendment) prohibition against involuntary servitude within the U.S. and its jurisdictions.

The other part of the 7.6 billion hours refers to the work done by non-government employees of private sector businesses and other organizations (including nonprofits which are exempt from the income tax but still must collect information and file regular reports with the IRS).

While these employees are paid by their employers, the time spent on IRS compliance work adds nothing, other than protection for their employer from prosecution by the IRS, to add to their organization’s earnings or mission.

The 7.6 BILLION Hours of Tax Work are NOT Compensated by the Federal Government

Many of the 7.6 billion hours cited above refer to unpaid, government mandated work by private citizens outside of their paid work hours. This despite the Constitution’s (Thirteenth Amendment) prohibition against involuntary servitude within the U.S. and its jurisdictions.

The other part of the 7.6 billion hours refers to the work done by non-government employees of private sector businesses and other organizations (including nonprofits which are exempt from the income tax but still must collect information and file regular reports with the IRS).

While these employees are paid by their employers, the time spent on IRS compliance work adds nothing, other than protection for their employer from prosecution by the IRS, to add to their organization’s earnings or mission.

What it Would Cost to Pay 3.8 Million Workers

Using U.S. Department of Labor’s Bureau of Labor Statistics data, the IRS Taxpayer Advocate estimated that total cost of hiring 3.8 million workers to do the 7.6 billion hours of work needed to file taxes came to 193 BILLION DOLLARS (in 2006).

This $193 Billion is unpaid work by individuals and organizations. Further, this $193 Billion represents 14% of the $1.4 TRILLION total revenue the Tax Advocate reported as collected in income taxes by the IRS in 2006.

In addition to unpaid work of collecting and reporting data needed to file taxes, there is also the actual dollars spent by individuals and organizations for professional assistance with compliance and filing that is paid to accountants and other tax professionals.

According to a May 20, 2013 study by Jason J. Fichtner and Jacob Feldman of the Mercatus Center at George Mason University entitled The Hidden Costs of Tax Compliance, American individuals and businesses paid between $67 billion and $378 billion annually on professional tax compliance assistance.

This is the cost of having taxes prepared and filed and does not include the cost of professional assistance with responding to IRS requests and audits.

In addition to the time and out of pocket cash costs paid by taxpayers to gather data and pay their taxes, there is also the cost of the Internal Revenue Service (IRS) itself. Taxpayers pay for these costs with their taxes.

For the fiscal year ending on September 30, 2012 the total budget for the IRS was 12.1 Billion dollars. At that time the IRS employed a total of 90,280 employees. While income taxes are the major part of the operations of the IRS, these numbers refer to the entire IRS and not just the resources devoted to collecting income taxes.

Naturally, the IRS only uses its own direct costs to compare to the total tax revenue collected in calculating the cost of administering the income and other taxes it collects.

This apples to spinach, comparison enables the IRS come up with very impressive figure showing that it spends just under fifty cents for each hundred dollars of tax revenue collected. Of course this ignores its own Taxpayer Advocate's figure which shows that the uncompensated work burden placed upon individuals and organizations comes to almost 14% of income tax revenue alone.

Tax Expenditures

The driving force behind the ongoing massive expansion of the U.S. Tax Code each year is the result so called tax expenditures. A tax expenditure is a loophole that is added on to the law and has the effect of creating a tax deduction for a specific group or type of economic activity.

For instance, one of the most common and most popular tax expenditures is the home mortgage interest deduction. People who purchase a home and pay for it with a mortgage, or obtain a mortgage on their existing home other real estate for personal use, are able to deduct their interest paid on the mortgage each year from their income. This has the effect of reducing their taxable income by the amount of the mortgage interest paid.

While this is a benefit to individual homeowners with mortgages, the real beneficiaries are the real estate and construction industries who benefit from the increase in demand for construction and sale of single family homes. While individual home ownership can be beneficial for individuals and the economy, it is not necessarily a good thing in every case. (In the interest of full disclosure, I do own a home with a mortgage and I take advantage of this tax expenditure or deduction when I file my taxes each year).

This tax deduction is a major reason why people decide to own rather than rent even though, realistically, home ownership is not a good option for everyone.

The 2008 housing market collapse and severe recession that has followed was largely the result of thousands of people who were not good credit risks to begin with, suddenly finding themselves unable to make their mortgage payments and losing their homes as a result. This was a severe financial blow to both the affected individuals and the U.S. economy as a whole.

Most Tax Deductions Benefit Big Corporations and Wealthy Individuals

According to an October 25, 2012 report by the Mercatus Center at George Mason University entitled A Trillion Little Subsidies by Jeremy Horpedahl and Brandon Pizzola, of the 33% of taxpayers who elect to itemize deductions, only 20% of those itemizing claim the mortgage interest deduction. Further, according to the report, two-thirds of this 20% claiming the deduction have incomes in excess of $100,000.

The tax cuts enacted during the Bush Administration may be responsible for this decrease in the use of the mortgage interest deduction as, for many lower income people, the lower rates made the standard deduction on the shorter Form 1040-A, which does not provide for itemizing of expenses, more attractive both financially and in terms of reduced recordkeeping.

However, based upon their own past experience or the experience of others, many people probably continue to choose ownership over renting due to the tax deduction and don’t learn that this is not their best option, taxwise, until they go to file their taxes.

Unfortunately, according to the Mercatus Center paper, the home mortgage interest is but one of thousands of tax deductions available. A majority of these deductions affect far fewer people, most of whom are affluent, and, in addition to the economic distortion they cause, result in close to one TRILLION DOLLARS worth of potential income tax receipts being diverted to selected taxpayers in the form of deductions which reduce their tax liability.

Practically everyone who is concerned about the complexity of the tax code and the numerous problems associated with the complexity agrees that the ever expanding river of new deductions or tax expenditures must be halted and all or most of the existing deductions eliminated.

Of course almost everyone will want to save deductions which benefit them. However, this close all loopholes but mine, is not what really stands in the way of serious tax reform.

Progressive Income Tax and Crony Capitalism

The real problem is the progressive feature of the income tax and the opportunity it presents for left leaning politicians to fan the flames of class warfare.

In addition political demagoguery, the progressive income tax also leads to corrupt crony capitalism.

Crony capitalism is a political environment in which private business leaders fund politicians in return for preferential treatment and other favors from the government leaders. This lets these crony capitalists generate profits without the usual work and risk taking that is the hallmark of free market capitalism.

Crony Capitalism is the exact opposite of crony capitalism.

How a Progressive Income Tax Works

A progressive income tax is a tax which applies higher rates to higher levels or brackets of income.

For instance, an income tax could have three brackets, each with a progressively higher rate - a 15% which taxes all income from $1 to $25,000 at a rate of 15%, a 50% bracket which taxes all income between $25,001 to $50,000 at a rate of 50% and an 80% bracket that taxes all income in excess of $50,000 at a rate of 80%.

In this system a person earning $90,000 would pay 15% on the first $25,000 of their income, 50% on their income between $25,001 and $50,000 and 80% on the last $40,000 (i.e., that portion of their income between $50,000 and $90,000) worth of income.

Socking It To the Rich

Political demagogues can gather votes from the lower income masses by demonizing the higher income minority and capitalizing on the lower income group’s feelings of envy toward the higher income group. Politicians of this ilk do this by promising to soak the rich with higher taxes.

However, when these politicians get elected and vote to impose the higher taxes the result is to discourage work and risk taking investments by the wealthier group which has the effect of reducing economic growth and job creation - as well as reducing total tax revenues since there is very little income to tax in the higher brackets when many wealthy people elect to reduce their income and avoid higher taxes by working and investing less..

The way to get around this is to publicly sock it to the rich with high taxes and then quietly enact numerous special tax deductions that have the effect of not only negating the effect of the high tax rates but also frequently resulting in those with the highest incomes paying a lower percentage of their income in taxes than lower income people.

The most blatant example occurred in the late 1960s during testimony before a Congressional committee on taxation by David Rockefeller, the then Chairman of Chase Bank and younger brother of former Vice President and New York Governor, Nelson Rockefeller.

You know, gentlemen, that I do not owe any personal income tax. But nevertheless, I send a small check, now and then, to the Internal Revenue Service out of the kindness of my heart.

David Rockefeller in testimony before before Congress in 1968

David Rockefeller was, and still is, one of the wealthiest men in America. When he uttered these words in the late 1960s the top federal income tax rate was 70% on income over $200,000, yet, thanks to deductions and exemptions, David Rockefeller didn’t legally owe any taxes.

While running for his second term in 2012 with a class warfare platform calling for higher taxes on the rich, President Obama experienced some momentary embarrassment when he found himself an example of the perverse effect of the tax code in the rich.

Like his wealthy, socket to the rich, billionaire supporter, Warren Buffett, President Obama actually ended up paying less, rather than more, taxes.

It was discovered that President Obama, despite having received a total of $844,585 in gross income for 2011, ended up paying a lower percentage of his income than his White House secretary, Anita Decker Breckenridge, had paid on her 2011 annual income $95,000.

Like, David Rockefeller and Warren Buffett (who also paid a lower percentage of his income on taxes than did his secretary on her much lower income), President Obama was able to legally reduce his tax liability by taking advantage of many of the numerous deductions and credits available to high income earners.

Unlike, David Rockefeller who had owed nothing in taxes in the 1960s,, President Obama did end up paying $162,074 which came to 20.5% of his adjusted gross income of $789,674. While, the dollar amount of Ms Breckenridge’s total tax bill was less than the President’s, the percentage of her income paid in federal taxes was larger than the percentage of income that President Obama paid.

A Solution: Eliminate All Deductions and Reduce Tax Rate

If we are serious about increasing tax revenue from the rich, the solution is to eliminate all deductions and credits for everyone and offset this loss with a lower rate.

While an income tax can be one of the most efficient, in terms cost of collection, and fair, in terms of people’s ability to pay, we should do away with the progressive aspect of the tax.

In terms of both efficiency and fairness, the present progressive system with its various rates and numerous deductions, should be replaced with a single flat rate that applies to everyone.

To encourage work and investment as well as protect the lowest income segment of workers, such a tax could exempt the first few thousand dollars of everyone’s (from poorest to richest) from tax and then tax all income in excess of that amount at a single flat rate.

Lowering Tax Rate Would Increase Cost of Tax Avoidance

While taxing wage income is simple being the sum of an employee’s gross earnings for the year, other types of income (such as profits, rents, royalties, etc) usually require the recipient incur costs and risk in generating that income. However, by following Generally Accepted Accounting Principles (GAAP) individuals in organizations could subtract costs from revenue and pay taxes on the remainder.

Of course, there are ways to game non-wage income to reduce or make it vanish for tax purposes. However, by keeping income tax rates low, the incentive for doing this would be greatly reduced.

  • First of all, finding creative ways to legally avoid paying taxes come with a price and low tax rates can result in finding that paying the actual tax is less than paying for ways to avoid paying the tax.

  • Secondly, doing away with all the complex rules, loopholes and deductions in the current code will add to the difficulty and expense of finding legal ways of limiting one’s tax obligations.

  • Finally, fewer people gaming the system would result in the IRS being better able to use their resources to target cheaters thereby increasing the odds of being caught and fined. Here again, the low rates combined with the fines and other costs of trying to reduce or avoid one’s tax liability would usually exceed the cost of simply paying one’s taxes.

Form 1040 EZ - The Simplest Income Tax Form

The Simple 1040EZ tax form is the easiest income tax form to complete
The Simple 1040EZ tax form is the easiest income tax form to complete

A Constitutional Amendment Is Needed

While the system described above could be voted into law by a simple majority in Congress voting to do so, given the nature of politics, the lifespan of such a law would be short as special interests and members of Congress would immediately begin voting on exceptions to the law.

What is needed is a constitutional amendment that puts strict limits on the power of the federal government to levy taxes. Such an amendment should:

  • Forbid any type of progressive income tax other than one limited to no more than two rates with one of the rates being zero percent.
  • Set a maximum rate for income taxes and this rate should be relatively low (20% or less)

  • All tax legislation and any regulatory legislation that results in increased costs imposed upon the American people, must be in a single bill dealing with that item only. Further, it must be passed with a roll call vote and by a majority of both houses of Congress with absent and abstaining members being counted as having voted ‘No’.

  • The date for filing taxes should be moved from April 15th to election day.

Vast Majority of Americans are Not Opposed to Paying Taxes

Even our forefathers who revolted against England over the taxes imposed by King George and Parliament, were not totally opposed to paying taxes.

Most historians now agree that the colonists had basically a free ride during the series of colonial wars (commonly known in the U.S. as the French and Indian Wars). Most of the cost of defending the colonies had been borne by British troops and taxpayers with colonial militia helped with the fighting while governments in the colonies helped pay for some local defense.

In their book, A Patriot’s History of the United States, authors Larry Schweikart and Michael Allen point out that it wasn’t just the financial burden of the taxes (which, in many instances was relatively small) that upset the colonists, but rather the anticipated army of royal bureaucrats and customs officers who would be sent over to administer the current and future taxes levied by Parliament.

Our current massive income tax, which no one understands and the costs of complying equal or exceed the taxes themselves, has become the nightmare that our forefathers fought to save us from over two centuries ago.

You Are One of 50,000,000 Americans Who Must Fill out an Income Tax Return By March 15. File Yours Early

IRS Poster Reminding People To File their 1944 Tax Returns
IRS Poster Reminding People To File their 1944 Tax Returns | Source


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    • Chuck profile image

      Chuck Nugent 4 years ago from Tucson, Arizona

      Genna East - thanks for visiting and for your comment.

      Having the use of billions of dollars, interest free, courtesy of the taxpayers is a nice chunk of change for Uncle Sam. However, given today's ultra low interest rates, most of us taxpayers don't lose that much in interest foregone.

      Thanks again for your comments.

    • Genna East profile image

      Genna East 4 years ago from Massachusetts, USA

      Interesting article, Chuck. My main complaint is the interest the government garners from our overpayments of income taxes. We are refunded, but Uncle Sam keeps the interest.

    • Chuck profile image

      Chuck Nugent 4 years ago from Tucson, Arizona

      Larry - you make some very good points here.

      Obviously, one Hub can't contain all of the answers to a problem of this magnitude. However, my intention was to first, highlight the huge cost the tax imposes on individuals and the economy - and these costs are not the taxes paid but the cost of filing one's taxes while trying to comply with the vast sea of tax laws and regulations. Second, to point out how the progressive income tax is encouraging the growth of corrupt crony capitalism. While more subtle and not yet as bad as in places like Vladamir Putin's Russia, this is a growing problem.

      The real solution to this problem is a smaller Federal Government that is more akin to our founding father's vision than the huge and growing government we have now. The income tax, without Constitutional limits, is the food that fuels the growth of this huge Federal Government.

      Thanks again for your thought provoking comments.

    • profile image

      Larry Wall 4 years ago

      You used a familiar phrase about social program. What do you include in social programs, food stamps, aid for Women and Infant Children (when the mother is single and has no income) supplementing flood insurance, unemployment compensation, (only used when state unemployment ends) medical research, and the list goes on.

      I will not disagree that tax money is often wasted. However, a constitutional amendment is not going to stop waste. It might reduce it and it might prevent some worthwhile programs from being enacted.

      Also, you may be setting yourself up for a catch 22. The second largest source of income in this country comes from offshore oil and gas exploration. A Congress, seeking money, could lift the moratoriums off the east and west costs, ANWR and other areas and produce a large amount of money. The environmental community would be opposed to it, but consumers might like it because increased production will reduce gasoline and utility bills. I worked 22 years for an oil and gas trade association in Louisiana, so I have some knowledge about this.

      Tax reform is needed, but if you hamstring the hansds of Congress too much,they will find another way. We could end up with a national sales tax. The tax on gasoline could go up. Interstate highways could be turned into toll roads, admission to national parks could be more expensive. Congress will find money. Also, would you eliminate the earned income tax credit, the Affordable Health Care Act Credit, the extra exemption you get when you are over 65 or if you are blind.

      Finally, some might think that eliminating deductions will increase the amount of income from Social Security Taxes. Congress will have to raise the limit on income before Social Security Taxes are increased.

      I am not trying to be argumentative. But on two different occasions I attended meetings where two different congressmen said they were going to pass a flat tax next year. Not only did they fail to pass the tax, they failed to get re-elected.

    • Chuck profile image

      Chuck Nugent 4 years ago from Tucson, Arizona

      Larry Wall - thanks for your comments.

      I agree that if all deductions were eliminated Congress would soon be voting them back in. That is why a Constitutional amendment is needed to mandate that income taxes have a maximum rate, not be progressive and limited to being used to raise funds for the Federal government and not for social engineering.

      As to charitable deductions, many marginal ones may go out of business. These are the same ones that spend huge amounts on fundraising and attract people looking for a tax deduction without knowing what the charity does. People have been supporting charitable causes since ancient times - long before there were income taxes and before governments became involved in helping the less fortunate. Hospitals, orphanages, poor houses and other institutions that help the poor, sick and other unfortunates have a long history of being started by and supported by private contributions only.

      As to state and local taxes, residents of high tax states and municipalities will be hurt by not being able to deduct these taxes paid. However, by capping the Federal rate at a low rate, people's Federal taxes will be much lower even without deductions. Further, as the Mercatus study I cited showed most of these deductions available today are only used by upper income people. Finally, those living in a high tax municipality can avoid the taxes my moving to another city and those in high tax states can move to a lower tax state. Every decade the Census shows movement from the highly taxed areas of the northeast to the sunbelt and it is not just for the weather as I am one of those who has moved and not regretted it. However, one cannot escape the Federal income tax by moving abroad as all income eared by a U.S. citizen from anywhere in the world is subject to the Federal Income tax regardless of where that citizen lives.

      By allowing individuals to deduct sales and property taxes from their Federal Income tax, the Federal government is in effect subsidizing those areas. Take away the deductions for such taxes and state and local officials will either reduce their spending or risk being voted out of office or having increasing numbers of taxpayers vote with their feet and move.

      Thanks again for your comments.

    • profile image

      Larry Wall 4 years ago

      I will agree the tax code needs a major overhaul. I will not agree with the no deduction theory. If all deductions are eliminated, charitable contributions will drop. A tax break should not be a reason for giving to charity, but for many people it is. Tax deductions for unusual medical expenses, for example more than 10 percent of your gross income should be allow. I would even agree to not being allowed to count insurance premiums.

      Of course your realize that reducing the amount of refunds people receive, the state taxes, which are based on the total adjusted income will increase, since fewer deductions means more taxable money that some states can levy.

      As far as the high income people, set a minimum tax that they must pay on all income over $500,000 or the number of your choice--no deductions will apply. The tax rate should not be excessive.

      If every deduction was eliminated, most would be back on the books in a few years. For instance, my area levies a nine percent sales tax on all purchases. That tax is deductible. You can either save all your receipts and come up with the actual number or use the IRS formula, which is a lowball number, but much easier to use. I do not believe I should have to pay taxes on my taxes. The same is true for taxes levied on your primary residence. I am in about four overlapping taxing districts and my property tax bill for 2013 was $600+. I should not have to pay taxes on that. People in other states pay much higher property taxes and would suffer a bigger impact.

      Finally, at the state level, I am required to report the purchases I make online. At one time, the tax was only levied if the online seller had a physical presence in the state. Now, it is any online sale that terminates in my state.

      I agree the tax code needs overhauling, but like every major effort, you have to be aware of the unintended consequences, which in this case would be a drop in charitable contributions, higher state income taxes and no provision for catastrophic medical expenses.