The Internal Revenue Service’s National Taxpayer Advocate is urging Congress to make tax reform its highest priority and to simplify the federal tax code by reassessing the need for every tax expenditure, including the exclusion of tax-exempt municipal bond interest from income.

Nina E. Olson made the plea in an annual report to Congress released Wednesday that says lawmakers should “employ a zero-based budgeting approach” to comprehensive tax reform that “starts out with the assumption that all tax benefits will be eliminated and adds tax benefits back only if members conclude that the public policy benefits ... outweigh the complexity burden.”

Mike Nicholas, president and chief executive officer of Bond Dealers of America, said, “In a test of whether benefits outweigh complexity burdens, tax exempt bonds will pass with flying colors – while the complexity created by capping the exemption will fail that test.  Tax exempt bonds have a 100-year track record of stability for investors, and their broad acceptance means state and local government issuers have a simple mechanism for affordably financing critical infrastructure.  The federal government should not tinker with this equation.”

Zero-based budgeting would be a radical change from traditional budgeting. Historically, the government and Congress assumes an existing baseline and approves changes to it. But with zero-based budgeting there is no baseline. Every line item must be approved for inclusion in the budget.

The report broadly defines tax expenditures as exclusions, exemptions, deductions, credits, preferential rates and deferrals.

It lists 11 exclusions and deductions that it said account for 80% of the total cost of tax expenditures, citing JCT data.

The exclusion of interest for state and local bonds is ninth on the list, with a cost of $25.7 billion for fiscal 2013.

Olson’s report acknowledges that the largest tax expenditures have wide-ranging support. Whenever proposals are made to reduce them, affected groups mobilize quickly to generate public opposition, the report said.

But broad support for tax reform can be built if there is a substantive dialogue about the required trade-offs between tax rates and tax breaks, Olson said in the report.

“An uninformed taxpayer who hears he may lose a tax break will instinctively want to keep it to prevent his tax bill from rising,’ the report said. “An informed taxpayer often will have a very different reaction because she understands she will be losing a tax break but probably will not pay more (or at least not much more) because rates will be lowered.”

The Joint Committee on Taxation projected that for fiscal 2013, which began Oct. 1, tax expenditures will cost about $1.09 trillion, while individual income tax revenue will total about $1.36 trillion, Olson’s report noted.  

To put those numbers in perspective, “if Congress were to eliminate all tax expenditures, straight math indicates it could cut individual income tax rates by 44% and still generate the same amount of revenue it collects under current rules,” the IRS said in a release on the report.

Olson’s call for tax reform is based on an analysis of IRS data by her office that shows U.S. individuals and businesses take more than 6.1 billion hours and spend $168 billion to complete filings required by the federal tax code.

The tax code contains almost four million words and, on average, has more than one new provision added to it daily, the report said.

Nearly 60% of taxpayers hire paid preparers and another 30% rely on commercial software to prepare their returns, the report said.

Olson also recommends Congress “fence off” or “sequester” IRS funding from the rest of the federal budget its funding mechanism is stabilized and it doesn’t have to compete with other agencies.

“The plain truth is that the IRS’ mission trumps all other agencies’ missions,” Olson told lawmakers.

Meanwhile, the General Accountability Office, released a report Wednesday containing a framework for lawmakers to use to evaluate tax expenditures.

The report, done at the request of Rep. John Lewis, from Georgia, the top Democrat on the House Ways and Means Committee’s oversight subcommittee, notes that generally “exclusions, exemptions and deductions are worth more to taxpayers in higher tax brackets.”

The report poses a series of questions for taxwriters to consider as the weigh whether to continue various tax expenditures.

The key questions are what is the purpose of a tax expenditure and how successful is it in achieving its purpose.

Even if a tax expenditure is achieved, it is good policy? the report says lawmakers should ask.

One key consideration would be whether the benefits of the tax expenditure exceed its costs, GAO said.

Does the tax expenditure generate net benefits in the form of efficiency gains for society as a whole and is it fair and equitable, the report asks. Lawmakers should consider who actually benefits from the tax expenditure, GAO said.

Is the tax expenditure simple, transparent and administrable? the report asks.

How does it relate to other federal programs? GAO asked.  For example, GAO said, lawmakers should consider whether the tax expenditure overlaps other federal initiatives or efforts.

GAO says lawmakers also should ask what are the consequences to the budget from the tax expenditure and whether these are captured by the Joint Committee on Taxation’s estimates.

Finally, GAO says lawmakers should ask whether there are alternatives to the tax expenditure that might more effectively achieve its purpose.

Lawmakers should consider whether the taxpayers’ claims for the tax expenditure can be capped or whether taxpayers’ eligibility for the tax expenditure can be restricted, GAO said.

The agency said an example of this might be limiting itemized deductions for taxpayers with income above a certain threshold.

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