The United States Faces a Large and Growing Structural Budget Deficit

Over the long term, the United States faces a large and growing structural  budget deficit primarily caused by known demographic trends and rising  health care costs, and this deficit is exacerbated over time by growing  interest on the ever larger federal debt. Individual income tax policy, tax  expenditures, and enforcement need to be key elements of the overall tax  review. The Individual Income Tax Is the Largest Single Source of Federal Revenues

The individual income tax has long been the single largest source of  federal tax revenue. Revenue from the individual income tax  has historically accounted for between 40 percent and 50 percent of total  federal tax revenue. Individual Income Tax Complexity, Compliance, and Efficiency Costs and Equity Concerns Contribute to Calls for Reform

Concerns about the complexity, efficiency, and equity of the individual  income tax have motivated calls for a substantial restructuring of the tax  or its replacement with some form of consumption tax. The widely  recognized complexity of the tax results in (1) significant compliance  costs, frustration, and anxiety for taxpayers; (2) decreased voluntary  compliance; (3) increased difficulties for IRS in administering the tax laws;  and (4) reduced confidence in the fairness of the tax. The individual  income tax also causes taxpayers to change their work, savings,  investment, and consumption behavior in ways that reduce their well- being. The tax exclusion for the exclusion of employer- provided health insurance from individuals’ taxable income, discussed in  text box 1, is another example of an income tax provision that clearly  reduces economic efficiency. Likewise, concerns have been expressed about the equity of  many specific features of the tax, such as:    marriage penalties (and bonuses) built into the tax under which the  combined tax liabilities of two individuals differ, depending on whether or  not those individuals are married;  the inconsistent treatment between taxable wages and salaries and other  components of total employee compensation, such as employer-provided  health benefits that are not taxed;  the fact that many low-income individuals face high effective marginal tax  rates over certain income ranges as the benefits of tax preferences, such  as the earned income tax credit, phase out;  the provision of certain tax benefits in the form of deductions, which are  more valuable to taxpayers in higher income brackets, rather than as tax  credits;  the requirement that a taxpayer must own a home in order to receive the  significant advantage of tax-preferred borrowing; and  the greater ease with which self-employed individuals can underreport  income, compared to employees whose incomes are subject to  withholding and third-party reporting. The difficulty in ensuring compliance is underscored  by the tax gap—the difference between the taxes that should be paid  voluntarily and on time and what is actually paid—that arises every year  when taxpayers fail to comply fully with the tax laws. About 70 percent of the gross tax gap for tax year 2001, or an estimated  $244 billion, was attributed to the individual income tax. Improving compliance and reducing the tax gap would help improve the  nation’s fiscal stability. Even modest progress would yield significant  revenue; each 1 percent reduction would likely yield nearly $3 billion  annually. Comparing Proposals on Common Dimensions

In moving forward on tax reform, policymakers may find it useful to  compare proposals on common dimensions. First, is the tax base as broad as possible? Does the proposed system raise sufficient revenue over time to fund our  expected expenditures? The economic efficiency costs of our current tax system likely will  become an even more important issue as we grapple with the nation’s  long-term fiscal challenges. Because any tax system can be subject to tax gaps, the  administrability of reformed systems should be considered as part of the  debate for change. Our publication, Understanding the Tax Reform Debate: Background,  Criteria, and Questions, may be useful in guiding policymakers as they  consider tax reform proposals.
Why GAO Did This Study

The federal government currently relies heavily on the individual income tax and payroll taxes for about 80 percent of its total annual revenue. Long-range projections show that without some form of policy change, the gap between revenues and spending will increasingly widen. The debate about the future tax system is partly about whether the goals for the nation's tax system can be best achieved by reforming the current income tax so that it has a broader base and flatter rate schedule, or switching to some form of consumption tax. This testimony reviews the revenue contribution of the current individual income tax as well as its complexity, economic efficiency, equity, and taxpayer compliance issues; discusses some common dimensions to compare tax proposals; and draws some conclusions for tax reform. This statement is based on previously published GAO work and reviews of relevant literature.

What GAO Found

The United States faces a large and growing structural budget deficit as current projected revenues are not sufficient to fund projected spending. The individual income tax has long been the largest source of federal revenue--amounting to $927 billion (7.5 percent of Gross Domestic Product (GDP)) in 2005. (Total revenues that year amounted to 17.5 percent of GDP.) Income tax policy, including existing tax expenditures, such as the exclusion of employer-provided health insurance from individual income, and enforcement approaches, need to be key elements of a multipronged approach that reexamines federal policies and approaches to address our nation's large and growing long-term fiscal imbalance. Concerns regarding the complexity, efficiency, and equity of the individual income tax have contributed to calls for a substantial restructuring of the individual income tax or its full or partial replacement with some form of consumption tax. The widely recognized complexity of the tax results in (1) significant compliance costs, frustration, and anxiety for taxpayers; (2) decreased voluntary compliance; (3) increased difficulties for the Internal Revenue Service (IRS) in administering the tax laws; and (4) reduced confidence in the fairness of the tax. The tax also causes taxpayers to change their work, savings, investment, and consumption behavior in ways that reduce economic efficiency and, thereby, taxpayers' well-being. Taxpayer noncompliance with the current individual income tax is another factor that could motivate reform. For tax year 2001, IRS estimated that noncompliance with the individual income tax accounted for about 70 percent of the $345 billion gross tax gap, which is the difference between the taxes that should have been paid voluntarily and on time and what was actually paid. Reducing this gap can improve the nation's fiscal stability, as each 1 percent reduction in the tax gap would likely yield about $3 billion annually. Reducing the tax gap within the current income tax structure will require exploring new and innovative administrative and legislative approaches. In moving forward on tax reform, policymakers may find it useful to compare alternative proposals along some common dimensions. These include, in part, whether proposed tax systems over time will generate enough revenue to fund expected expenditures, whether the base is as broad as possible so rates can be as low as possible, whether the system meets our future needs, and whether it has attributes that promote compliance. Our publication, Understanding the Tax Reform Debate (GAO-05-1009SP), provides background, criteria, and questions that policymakers may find useful.