Learning to Love Form 1040: Two Cheers for the Return-Based Mass Income Tax

By Lawrence Zelenak

No one likes paying taxes, much less the process of filing tax returns. For years, would-be reformers have advocated replacing the return-based mass income tax with a flat tax, federal sales tax, or some combination thereof. Congress itself has commissioned studies on the feasibility of a system of exact withholding. But might the much-maligned return-based taxation method serve an important yet overlooked civic purpose?

In Learning to Love Form 1040, Lawrence Zelenak argues that filing taxes can strengthen fiscal citizenship by prompting taxpayers to reflect on the contract they have with their government and the value—or perceived lack of value—they receive in exchange for their money. Zelenak traces the mass income tax to its origins as a means for raising revenue during World War II. Even then, debates raged over the merits of consumption-based versus income taxation, as well as whether taxes should be withheld from payroll or paid at the time of filing. The result is the income tax system we have today—a system whose maddening complexity, intended to accommodate citizens in widely different circumstances, threatens to outweigh any civic benefits.

If sitcoms and political cartoons are any indication, public understanding of the income tax is badly in need of a corrective. Zelenak clears up some of the most common misconceptions and closes with suggestions for how the current system could be substantially simplified to better serve its civic purpose.

• Language: English
• Publisher: University of Chicago Press
• Release date: Mar 29, 2013
• ISBN: 9780226019086

Book preview

Lawrence Zelenak is the Pamela B. Gann Professor of Law at Duke Law School.

The University of Chicago Press, Chicago 60637

The University of Chicago Press, Ltd., London

© 2013 by The University of Chicago

All rights reserved. Published 2013.

Printed in the United States of America

22 21 20 19 18 17 16 15 14 13 1 2 3 4 5

ISBN-13: 978-0-226-01892-8 (cloth)

ISBN-13: 978-0-226-01908-6 (e-book)

Library of Congress Cataloging-in-Publication Data

Zelenak, Lawrence.

Learning to love Form 1040 : two cheers for the return-based mass income tax / Lawrence Zelenak.

pages ; cm

Includes bibliographical references and index.

ISBN 978-0-226-01892-8 (hardcover: alkaline paper) — ISBN 978-0-226-01908-6 (e-book)

1. Income tax–United States.   2. Tax returns–United States.   I. Title.

KF6369.85.Z454 2013

336.24'150973–dc23

2012027807

This paper meets the requirements of ANSI/NISO Z39.48-1992 (Permanence of Paper).

Learning to Love Form 1040

Two Cheers for the Return-Based Mass Income Tax

LAWRENCE ZELENAK

The University of Chicago Press

Chicago and London

CONTENTS

ONE: Tax Returns and Fiscal Citizenship

TWO: What’s So Special about a Return-Based Mass Tax?

THREE: Tax Protests, Tax Resistance, and Tax Cheating

FOUR: Tax Expenditures and Fiscal Citizenship

FIVE: The World War II Origins of the Return-Based Mass Income Tax

SIX: The Return-Based Mass Income Tax in Popular Culture

SEVEN: Simplify, Simplify

Notes

Bibliography

Index

ONE

Tax Returns and Fiscal Citizenship

Nobody likes Form 1040. Would-be reformers of the federal tax system accept the inevitability of taxes, but not the inevitability of tax returns. In The FairTax Book, their bestseller advocating the replacement of the income tax with a federal retail sales tax, Neal Boortz and John Linder trumpet the elimination of tax returns under their proposal: No complicated decisions, no tedious bookkeeping, no saved receipts and tax reporting forms. Oh, and no audits. . . . And April 15? It becomes just another lovely spring day.¹ Michael J. Graetz proposes a different reform—replacing the mass income tax with the combination of a value-added tax (VAT; a more sophisticated variation on a retail sales tax) and a residual income tax imposed only on persons with six-figure incomes.² This would return the income tax to its pre–World War II status as a tax imposed on only an affluent minority of the population. Graetz considers the elimination of tax returns for most Americans to be a major selling point of his proposal—so much so that he features it in his book’s title, 100 Million Unnecessary Returns.

Doing away with returns for most taxpayers would be possible even without repealing the income tax or sharply limiting its scope. About thirty countries have return-free income tax systems for most taxpayers, operating on the basis of exact withholding.³ Under an exact-withholding system, employers and other payers of taxable income items (such as interest and dividends) withhold and remit to the government the precise amount of the recipient’s tax on that income, thereby eliminating the need for tax returns to reconcile differences between amounts withheld and taxes actually owed. Congress has twice—in 1986, and again in 1998—ordered studies of the feasibility of a return-free income tax for at least some taxpayers.⁴ The Treasury Department and the Internal Revenue Service (IRS) dutifully produced the required studies,⁵ but no legislation has resulted.

It is no mystery why there is so much interest in eliminating the income tax return. Americans file in the neighborhood of 140 million individual income tax returns each year (because of joint returns for married couples, the 140 million returns are for close to 200 million taxpayers). Studies have estimated that taxpayers spend 3.5 billion hours each year working on their federal and state income tax returns (with most of that time spent on recordkeeping, rather than on actual return preparation).⁶ If that time is valued (conservatively) at $20 per hour, that is $70 billion worth of taxpayers’ time each year. Most taxpayers also have significant out-of-pocket return preparation costs. Roughly three in five taxpayers hire paid preparers to deal with the returns themselves (in contrast to the throughout-the-year recordkeeping, delegation of which is generally not practical), at an average cost of more than $200.⁷ Many of the two-in-five do-it-yourself taxpayers pay substantial amounts for the assistance of TurboTax or other return-preparation software. Total out-of-pocket return preparation costs, for both customers of paid preparers and do-it-yourself software users, are about $15 billion annually.⁸ There is no way to quantify the psychic costs—in worry and aggravation—of wrestling with income tax recordkeeping and number crunching, but those costs are undeniably significant as well.

With no shortage of proposals to eliminate the individual income tax return, and with the return requirement imposing major costs, why does the Form 1040 remain so very much with us? It is true that H&R Block, Jackson Hewitt, and Intuit (the owner of TurboTax) have a vested interest in the Form 1040 and would fight to protect that interest if necessary (as Intuit has done when faced with a threat of reduced demand for its California state income tax software⁹), but at the federal level that interest has never been seriously threatened.

The federal income tax features an immense number of bells and whistles, all designed to fine-tune tax liabilities according to numerous aspects of taxpayers’ circumstances. Six different marginal tax rates, from 10 percent to 35 percent, apply in six different income ranges. Deductions are allowed not only for home mortgage interest, state and local taxes, and contributions to charity, but also for alimony, casualty losses, medical expenses, individual retirement account (IRA) contributions, moving expenses, and on and on and on. Credits are allowed for (among many other things) childcare expenses, college tuition and fees, adoption expenses, having dependent children, being a low-wage worker with dependent children, and purchasing an electric car. And then there is the alternative minimum tax (AMT), which applies to millions of taxpayers, and which has its own set of tax rates and its own rules for allowable deductions and credits.

Fine-tuning of this sort is obviously impossible under a tax system—such as a retail sales tax or a VAT—that imposes tax on transactions rather than on individuals. Such a system can achieve modest adjustments for family size by sending each household an annual rebate check equal to the tax imposed on the household’s subsistence-level consumption, but the byzantine adjustments of the current income tax are far beyond the capacity of a retail sales tax or VAT. A return-free income tax could accommodate somewhat more complexity than a retail sales tax or VAT. Under a return-free income tax with exact withholding, employers (and other payers of taxable income items) must have enough information about their employees to determine the precise amount of required withholding. The United Kingdom’s Pay as You Earn (PAYE) exact withholding system has proven itself compatible with a small number of different tax rates, and with limited tax benefits for home mortgage interest and charitable contributions.¹⁰ These modest complications fall far short, however, of the elaborate filigree adorning the current US income tax.

As burdensome as tax returns surely are—in terms of taxpayers’ time, dollars, and aggravation—that burden is unavoidable if we are to have a tax system that is finely attuned to the detailed circumstances of each taxpayer. Proposals to eliminate tax returns are necessarily proposals for major substantive simplification of the tax laws. Reform proponents typically argue that the bells and whistles of the current system—the progressive rates and the proliferating deductions and credits—are bad tax policy quite apart from the compliance burdens that tax returns impose on taxpayers. They argue that adoption of their proposals would have a double benefit—a fairer distribution of tax burdens under simpler rules and the elimination of tax returns for many or all Americans. But, if one believes (as Congress must, judging by its legislative choices) that the complexities of current law constitute good policy, then one accepts the tax return requirement as regrettably necessary for achieving the desired distribution of tax burdens.

In this book I defend tax returns from a very different perspective. I argue that tax returns serve important purposes apart from accommodating high degrees of complexity. One of those purposes is raising the tax consciousness of the average citizen, compared with the low level of tax consciousness that would prevail under a federal retail sales tax, VAT, or return-free income tax. The tax return filing process calls the taxpayer’s attention to the total amount of income tax that he has paid over the past year—a fact that would otherwise be obscured by the near invisibility of tax paid by withholding at the source and that would be even more thoroughly obscured under a retail sales tax or VAT. Prompted by that information, taxpayers may reflect—as they should—on whether they are receiving good value from the federal government for their income tax dollars.

Even more importantly, tax returns have a crucial role to play in the promotion of what might be termed fiscal citizenship. For most of the people most of the time, the most prominent and meaningful connection with the federal government is through the income tax. The near-universal tax return filing requirement defines and mediates the relationship between citizens and the federal government. The return-preparation process serves—or at least has the potential to serve—the important civic purpose of recognizing and formalizing the financial responsibilities of citizenship. Justice Oliver Wendell Holmes, Jr., famously remarked, Taxes are what we pay for civilized society.¹¹ The filing of a tax return, with its high visibility and ceremonial aspect, calls the taxpayer’s attention to his status as a taxpayer and a purchaser of civilization in a way that would be impossible under a return-free tax system.

In contrast with the claim of Boortz and Linder that the ideal fate for April 15 would be to become just another lovely spring day, April 15 should be recognized as a national holiday, Taxpayer’s Day. The act of paying taxes is important enough to merit that recognition. The holiday would reward taxpayers for fulfilling the financial responsibilities of citizenship, and taxpayers could use the holiday to reflect on the civic importance of their taxpayer status. Even if a national holiday is never introduced, more communities might follow the model of Lawrence, Kansas, which since 1987 has had a tax return filing party at its post office every April 15, complete with live music, dancing, and food.¹²

April 15 can and should be as important a civic occasion as the first Tuesday after the first Monday in November. Together, Tax Day and Voting Day symbolize the fulfillment of the two great responsibilities of citizenship. Former IRS Commissioner Mark Everson has noted the connection between tax filing and voting: [L]ast year [2004] 183 million people filed individual income tax returns. To put that number in perspective, it is fully half again the number of people who voted in the presidential election. In that sense, paying taxes is a unifying experience fundamental to our democracy and respect for the rule of law.¹³

This enthusiasm for the Form 1040 as a civic ceremony—as an exercise in fiscal citizenship—may seem hopelessly out of touch with the reality of the tax return preparation experience for most people today. If taxpayers experience the income tax as a complex mess—a fair description of the current tax—then their reflections on the income tax, and on the federal government more generally, may take a far-from-Holmesian turn. If confronting her Form 1040 fills a taxpayer with fear and loathing, the return preparation process is more likely to alienate her from the federal government than to strengthen her sense of fiscal citizenship. Former Commissioner Everson made this point as well: [T]hose who seek to comply but cannot understand their tax obligations may . . . ultimately throw up their hands and say ‘why bother.’¹⁴ After spending many miserable hours satisfying their filing obligations, taxpayers are not likely to be basking in the warm glow of Holmesian contemplation of their fiscal citizenship.

Although today the tax return filing requirement falls far short of its potential for strengthening fiscal citizenship, there is considerable evidence that it served that purpose effectively in the first few decades of the mass income tax, during and after World War II, when the income tax was simpler and the return preparation process was correspondingly less aggravating. There is reason to hope that tax returns could again effectively serve that purpose, if Congress were to restore the rules applicable to most taxpayers to the relative simplicity of earlier decades.

This book makes the case for retaining a return-based mass income tax not because such a system can accommodate highly complex rules for determining tax liabilities, but because of the potential of a return-based system to promote fiscal citizenship. Ironically, the very complexity made possible by a return-based mass tax threatens the civic benefits of return-based taxation. Because the civic benefits of tax returns are likely to be realized only under an income tax considerably simpler for the vast majority of taxpayers than today’s version, this book is—like those of Boortz and Linder, and Graetz, and many others—a proposal for tax reform. But it is a considerably more modest proposal than most—a proposal not to scrap the return-based mass income tax in favor of a return-free system, but to repair the return-based tax so its civic potential can be realized. The book offers two cheers for the Form 1040. It withholds the third cheer partly because the Form 1040’s civic benefits are more potential than they are currently realized, but also because even with simplified tax rules those benefits would come at a real cost—less than the cost of tax returns today, but still substantial—in taxpayer time, out-of-pocket expenses, and headaches.

A clarification is necessary at this point, concerning the definition of a return-free tax system. A handful of countries use a system called tax agency reconciliation, under which a country’s IRS-equivalent agency prepares a tentative tax return on a taxpayer’s behalf, using information provided to the agency by the taxpayer and by parties making taxable payments to the taxpayer. A taxpayer receiving a tentative return may sign and file the return as is, modify the return before signing and filing, or ignore the tentative return and prepare a return from scratch. The California Franchise Tax Board also offers tax agency reconciliation, under the appellation ReadyReturn, for some taxpayers.¹⁵ Although tax agency reconciliation is often described as a return-free system, that is obviously an inaccurate description. Under tax agency reconciliation, a taxpayer must still review, sign, and file a return. The required taxpayer involvement should be sufficient to generate the sense of tax filing as an important aspect of civic participation. In fact, the fiscal-citizenship–promoting character of the return-filing process might well be more pronounced for a taxpayer using tax agency reconciliation than for either a taxpayer preparing a return without assistance or a taxpayer hiring a paid preparer, because most of the negative feelings engendered by grappling with complexity (or by paying a surrogate to do so) would be eliminated.

The Road Ahead

Chapter 2 describes three major consequences of the federal government’s reliance on a highly visible return-based mass tax. First, the filing requirement is a crucial component of a compromise on the question of how visible and painful federal taxation should be. Coupled with inexact withholding, the return-based income tax has proven to be an enduring compromise between big-government proponents (who generally favor low-visibility, low-pain taxes, and for whom the ideal system might feature return-free exact withholding) and small-government proponents (who would prefer taxes to be as visible and as painful as possible, and for whom the ideal tax might be an income tax without withholding). The second—but perhaps most important—of the consequences is the one emphasized above. A return-based tax confers taxpayer status and a sense of fiscal citizenship in a way no retail sales tax, VAT, or return-free tax (including the current payroll tax used to finance Social Security) ever could. Third, the near-universal return-filing requirement, coupled with a tax return due date applicable to all individual taxpayers, has had the effect of focusing media attention on big-picture tax policy issues on and around every April 15.

Chapter 3 considers the return-based mass tax as a vehicle for not paying tax, in the case of tax protesters and tax cheaters. The income tax has been used extensively as a vehicle for protests by those at both ends of the political spectrum. A tax protest requires a tax that gives the taxpayer a choice as to whether to comply. The return-based mass tax gives that choice to almost everyone. Retail sales taxes, VATs, payroll taxes, and final-withholding return-free income taxes do not. Although there are obvious arguments against a tax system highly vulnerable to protests—it certainly makes life more difficult for the IRS—the openness to protests may serve an important safety-valve function. Perhaps the opportunity for income tax protests has forestalled more violent protests. In addition to its openness to protests, the return-based tax is also susceptible to widespread small-scale cheating, by failing to report income (of types not subject to information reporting by payers) and by overstating deductions (such as the deduction for charitable contributions). Again, although there are obvious arguments that this vulnerability to cheating is bad thing, there is also something to be said in its favor. From one perspective, it may create a sense that one is trusted by the government (within limits), which may foster a corresponding sense of trust in government. From another perspective, it gives the average person a sense of (again, limited) empowerment to resist Leviathan.

Chapter 4 describes how the existence of return-based mass taxation in the postwar era facilitated the explosive growth of tax expenditures—subsidies designed to further nontax policy goals, embedded in the income tax—including the home mortgage interest deduction, the charitable contributions deduction, the earned income tax credit (EITC), and an array of provisions serving various education- and environment-related purposes.¹⁶ This is not entirely to the credit of return-based taxation, because many of the tax expenditures are of doubtful merit. In fiscal-citizenship terms, however, one tax expenditure—the deduction for donations to charity—has been remarkably successful. The deduction enables taxpayers to decide whether to satisfy their financial obligations to society by paying a certain amount of tax, or by contributing a larger amount to charity. Saul Levmore has described this as taxes as ballots,¹⁷ thus analogizing citizenship exercised through the tax system to citizenship exercised through voting. The EITC, which functions as an antipoverty program for working parents and their children, can also be viewed as promoting a sense of economic citizenship, to the extent it achieves its purpose of ensuring that anyone who works full-time will be able to support his or her family at a level of basic decency.

Although the federal income tax has existed continuously since 1913, it did not achieve its current mass tax status until World War II. Chapter 5 describes the wartime conversion of the income tax to a mass tax. The need to finance the war made some form of federal mass tax inevitable, but it was far from inevitable that the income tax would be chosen as the vehicle of mass taxation. If not for the strenuous (and less-than-wholly-rational) opposition of the Roosevelt administration to a federal retail sales tax, the United States might have emerged from the war with a retail sales tax as the instrument of mass taxation and with an income tax applicable only to the economic elite. Even given the wartime decision to adopt a mass income tax, it was not inevitable that the tax would be return based. As Chapter 5 recounts, Congress came very close during the war to eliminating the return-filing requirement for most taxpayers by enacting an exact-withholding system.

Chapter 6 turns from political history to popular culture. It examines the treatment of the income tax in nearly one hundred radio and television situation comedy episodes from the 1940s to the present, as well as in more than two hundred New Yorker cartoons from the late 1920s to the present. The mass income tax and sitcoms emerged at nearly the same moment. Nothing has been