Paul L. Caron

Friday, September 11, 2020

Weekly SSRN Tax Article Review And Roundup: Holderness Reviews Walker's Tax Complexity And Technology

This week, Hayes Holderness (Richmond) reviews David I. Walker (Boston University), Tax Complexity and Technology:

Holderness (2017)Tax preparation platforms like TurboTax and TaxAct offer taxpayers a (relatively) easy way to complete and file their tax returns. Tax preparation businesses like H&R Block similarly ease the burden on taxpayers of completing and filing tax returns; those businesses also use technology to provide their services. Cumulatively, over 90% of individual taxpayers do their taxes with the help of these platforms or businesses, as opposed to filling out the returns themselves. Technology appears to be a tax simplification salve for the vast majority of individual taxpayers.

Not quite so fast, argues David Walker, in his draft article, Tax Complexity and Technology. While technology has undeniably simplified the return process for many, it has also helped mask the inner workings of the tax laws. Tax preparation platforms and businesses can operate like “black box” algorithms: just plug in the data and get a nice round number; don’t worry about how the number is reached. These black boxes allow for the complexity of the tax laws to grow.

Tax complexity, in and of itself, is not necessarily a bad thing. Returns that demand a lot of attention may raise awareness of the tax law. To increase equity among differently situated taxpayers, tax laws often must become more complex. Likewise, if the government wishes to incentivize certain activities through the tax laws, the complexity of those laws is almost sure to increase. As these examples indicate, there are many types of complexity associated with taxes; two of the most revenant types to Walker’s article are compliance complexity and rule complexity.

Compliance complexity refers to how difficult it is for taxpayers to fulfill their obligations under the law. Here, technology has shined, as noted above, tax preparation platforms and business (with their own technologies) have been embraced by individual taxpayers. Rule complexity, on the other hand, can be characterized as referring to how difficult it is for taxpayers to understand the law and incorporate that understanding into their life decisions. Here, according to Walker, technology has fared much worse.

Walker notes many symptoms of the black box effect described above, but two stand out. First, because of cognitive limitations or biases, individual taxpayers often underestimate their effective tax rates. This error can be beneficial to society because it reduces the deadweight loss associated with taxes. Taxpayers act as though their income-producing activities will be subject to less tax than the activities actually are, so they chose to engage in more of those activities, mitigating the disincentive imposed by the federal income tax. Assuming the tax dollars are well-spent, individuals may not be particularly harmed by this miscalculation, and society gets more beneficial behavior than might otherwise be expected. Individuals, though, might feel mistreated when their tax bill arrives.

The other prevalent symptom of the black box effect is that taxpayers fail to respond to incentives present in the tax law because they do not understand how those incentives affect their life choices. As incentives become more targeted and the rules become more complex, individuals need more help. This rule complexity is particularly problematic because higher-income taxpayers are able to afford tax planning assistance to ensure they respond appropriately to the incentives, but lower-income individuals do not have the same opportunities for assistance and end up missing out on tax incentives. The tax law becomes ineffective because of the complexity.

Walker’s solution is to promote tax planning technology rather than continuing to rely solely on tax preparation technology to address tax complexity. Tax planning technology can address the symptoms of the black box effect of tax preparation platforms and businesses by informing taxpayers of how they can make decisions that are responsive to incentives in the tax code. A side effect of this result would be to better inform individuals of their effective tax rates, which could prove socially harmful by increasing the deadweight loss society suffers because of the taxes. However, in Walker’s view, the government should provide tax planning technology targeted to lower-income individuals, where the deadweight loss problem is not as concerning as balancing the opportunities for tax planning assistance between low- and high-income taxpayers.

Walker’s thought-provoking proposal raises questions. For instance, how receptive would taxpayers be to tax planning technology? At first glance, the experience of tax preparation technology indicates that taxpayers would embrace tax planning technology, but the two are likely to have meaningful differences in implementation. Most individuals interact with tax preparation technology once a year and input their data for field population and little analysis. To be effective, tax planning technology would likely require continuous taxpayer interaction, a lot of taxpayer data, and a lot of analysis of that data. How many taxpayers would be willing to take on that personal cost? How many low-income individuals that might most benefit from incentives with public assistance-type aspirations would be worried about further government surveillance? Presumably some, and maybe many, taxpayers would embrace the technology, but would the benefits to those taxpayers outweigh the costs of developing and maintaining the technology?

Another concern is how the government would handle errors resulting from the tax planning technology. For honest mistakes, would taxpayers who relied on the government-provided technology be subject to the whipsaw of extra tax owed along with penalties and interest? On the less honest side, would the technology provide taxpayers with a roadmap for tax evasion by encouraging taxpayers to lie to get tax incentives to which they are not entitled but which the government might have a difficult time auditing?

Perhaps these are concerns for later down the road. Walker’s primary goal appears to be balancing opportunities for tax planning between low- and high-income taxpayers. High-income taxpayers certainly have been willing to undertake the personal cost of attaining tax planning assistance and have been known to engage in tax evasion, so maybe these concerns are just the costs of attaining this equity. Besides, as Walker notes, there are a plethora of benefits beyond pure tax reduction that come with understanding the tax laws that might encourage otherwise reluctant taxpayers to take up the tax planning software, and tax evasion by low-income taxpayers may be less concerning than tax evasion by high-income taxpayers. Technologies will continue to advance, why not use them to address the problems of all types of tax complexity? Tax Complexity and Technology opens a window into what doing so might look like.

Here’s the rest of this week's SSRN Tax Roundup:

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