IRS to increase “pre-crime” enforcement by Simon Black on April 12, 2011

April 12, 2011

Vina del Mar, Chile

Did you ever see Minority Report? It’s one of Steven Spielberg’s often forgotten about movies based on the short story by Philip K. Dick. In the movie, pre-couch Tom Cruise plays a police officer in the year 2054 who works for the highly specialized ‘pre-crime’ division.

Using a bizarre array of technology and metaphysics, the pre-crime division sees into the future and stops criminals in their tracks, arresting them before they commit a crime… sometimes before they even think about committing a crime.

This very elaborate and morally ambiguous law enforcement system is predicated on the government determining what your actions and intentions will be, often before you do. It’s not all science fiction.

A number of politicians and bureaucrats in Washington D.C. are seeking to step up the Internal Revenue Service’s powers, and technology, to essentially audit taxpayers before returns are even filed.

In remarks to the National Press Club last week, an IRS spokesman unveiled the agency’s vision for the “look forward” model in which most of the pertinent reporting information for the average taxpayer (W2, 1099, mortgage interest etc.) would be submitted to the IRS well in advance of the individual deadline.

After a massive upgrade in technology, the IRS would be able to pre-calculate what it expects to receive in taxes and instantly reject any return that doesn’t comply with its determination.

This may work fine and well for some wage earners… but start throwing in a few investment accounts, small business income, private partnerships, etc. and things can quickly diverge from the IRS estimates.

Imagine you start a new business on the side of your usual employment this year and take an initial loss due to ancillary startup costs. This wouldn’t factor into the machine’s pre-calculations of your tax liability, so you would be immediately rejected and flagged for additional scrutiny.

Makes you want to run out and start a business, or invest your capital in someone else’s, right? Not exactly.

Deep down, I think these people simply want to try and make things more efficient. Pre-crime is not the way to go. There are a number of countries that have incredibly successful tax codes, and there are common themes in all of them:

1) Keep it short. The Baltic countries are a great example of this– the entire Estonian tax code is about 70 pages, roughly 1/1000th the size of the US tax code (which is still prone to so much interpretation). It takes about 15 minutes to fill out an Estonian return, and you can do it online. In the Maldives, it’s even easier.

2) Keep it simple. When you have a tax code that’s so complex it has given rise to a multi-billion dollar preparation industry, you have a problem. There are dozens of different forms at the IRS, and over 20 versions for the 1099 alone! This is a system that is prone to massive flaws and a great deal of contradiction.

Hong Kong is a great example of a simple system. Taxes are levied at a flat rate of 15% based on the “territorial principal” that only income derived from Hong Kong is taxed. There is no capital gains tax, no VAT, no estate tax, etc. And yet, the biggest problem the Hong Kong government faces regarding taxes is how to give away their massive surplus.

3) Keep it low. When you make it easy and painless for people to pay taxes, it removes most of the incentives for them to cheat. In Singapore, tax rates are among the lowest in the world with a maximum rate of 20%. The capital gains rate is zero. The corporate rate varies from 0% to 17% (and keeps falling).

Under these circumstances, why cheat? By keeping rates low, the government is removing any incentive to engage in complicated (and costly) tax avoidance techniques. From a cost/benefit perspective, it’s much easier to comply when rates are low.

4) Keep it friendly. Creating an adversarial relationship with taxpayers doesn’t do anyone any favors. One of the key themes of the world’s most successful tax regimes is that they do not operate like a police agency that’s out to get people. This is a massive hurdle for the IRS to overcome.

Perhaps the polar opposite of this is Switzerland, where tax evasion is considered a civil matter, not a criminal matter. In Switzerland, the local cantonal tax authorities actually compete with each other for your business, rather than sticking you up for cash under penalty of imprisonment.

The US government is now searching for answers. Behind close doors, politicians are likely admitting to each other that the kitty is empty and they’re completely bankrupt. They don’t have to look far for solutions– the best models in the world are already in practice and have been successfully implemented.

Rather than making things easier, less painful, friendlier, and simpler, the US government seems to be taking the opposite approach– hiring more agents to sniff out ‘suspicious’ activity (defined in their sole discretion), raising taxes, and relying on fear and intimidation.

I suspect this path will have the opposite effect– instead of raising more money for a bankrupt government, it will continue to chase out productive people. More on that in a future letter.