Why we like our taxes complicated

Because you must file a tax return, you may as well get something out of this painful process — like an economics lesson.

I’m not going to go through Form 1040 or its “easier” counterparts 1040A or 1040 EZ line by line. Even if we don’t count the subparts, Form 1040 has 76 lines this year. In 1994 it had 65 lines. We’re adding one line a year.

An income tax return really only has to have four lines: income, tax, refund and payment. The other 72 lines are the result of well-intentioned representatives attempting to please their constituents and maximize their incumbency. This is the first economics lesson from Form 1040 — taxes are mainly about politics, not economics, but taxes have economic implications, mainly through the incentives they create.

After your name and address, the next lines on Form 1040 are about filing status. Here we see that the government recognizes that all relationships are not created equal. You get the best tax rate if you are married filing jointly, and one of you makes most of the income. Single people have higher tax rates for the same amount of income. Our tax system is based on the values of a 1950s TV sitcom.

The next lines are about exemptions, the number of people in your household for whom you get to subtract a certain amount in determining your taxable income. If you are one who worries about population growth, it’s best not to look at this part of Form 1040. Be fruitful and multiply is the message here. The more kids you have, the lower your taxes.

The next set of lines relates to income sources. You’d think this might be simple. Indeed, one part is straightforward — the forms of income. There’s a line for every conceivable form of income as the government leaves no tax base unidentified. By far the biggest component is wages and salaries, but we also find space for income from a sole proprietor and income in the form of what economists call DIRT — dividends, interest, rent, and transfers.

With a simpler tax system, once we’d added up our different sources of income, we’d be ready to compute our tax. But we don’t have a simple tax system. We have to adjust our income, and we can only adjust it downward.

Teachers in grades K-12 can subtract some of the cost of their purchased materials and supplies. But not if you are a college teacher (I admit some sour grapes here). Economists recognize this as testimony to the political power of public school teachers’ unions. By granting additional adjustments for college tuition and student loan interest, we subsidize higher education. Adjustments for individual retirement account contributions give an incentive to save for retirement. Adjustments for health savings accounts give an incentive to buy health care. We reward divorced individuals who pay alimony. We even support a mobile society by adjusting income for moving expenses. Do you think moving companies have lobbyists in Washington, D.C? You bet they do.

After we’ve made our adjustments (subtractions) to income, we subtract our exemptions and our deductions. About 65 percent of taxpayers use the standard deduction, $10,000 for couples filing a joint return in 2005. Others, primarily those with a lot of home mortgage interest, property taxes or charitable contributions, compute itemized deductions. As you might expect, these are more well-to-do taxpayers. According to the Center on Budget and Policy Priorities, about 72 percent had income greater than $50,000 in 2001. The distinction between those who itemize and those who don’t is very important in the state of Washington this year. Through itemizing, you can deduct either your sales taxes or your state income taxes, whichever is largest. In Washington there is no state income tax, so it’s a special break.

A very important economic lesson appears in the value of the standard deduction and the exemptions for 2005. They are higher than they were in 2004. In fact they have been growing since 1985, when inflation indexing took effect.

Finally, we come to the section on taxes and credits. Your tax appears in the tax tables. The tax tables are a little sneaky, however. You look up your taxable income, or your computer program does it for you, and it gives you a number for your tax. If your taxable income goes up, your taxes rise according the tax rate for the tax bracket you are in. But because we have the tax tables — and not tax rate schedules that present the tax as a percentage of income — these tax rates are hidden. This is economically unfortunate, as this is where we find the most important incentive effects of the tax system. How much does Uncle Sam (and Uncle Dirk in Idaho) get of additional income you earn?

We’re not finished yet. Congress and the president want to be nice to us one more time through credits. Credits are better than deductions, because they lower our tax, not just taxable income. All kinds of activities are favored here, such as sending your kid to day care, and adopting or having children. What a family-friendly country.

After we add some minor other taxes, we come to the final important sections — payments (mostly withholding from your paycheck), refund, or if you haven’t paid enough through withholding or estimated tax payments, the amount you owe. Because the distaste of having to write a check to the government in April is so intense, most get a refund from the IRS. It’s also a form of forced saving on the part of taxpayers, reflecting a lack of financial discipline. By getting a refund, we make an interest-free loan to the government every year. The government does not reciprocate. If we don’t pay in enough, they charge us interest and penalties.

So there you have it, an economic walk through Form 1040. Our tax system is complicated, and it’s that way because we want it that way, and politicians are quite willing to give us the complicated tax system we demand. And this is the main lesson from Form 1040: Don’t count on tax simplification any time soon. We’d have to give up too much to get it.