Taxing Complexity

• In Event: Tax Complexity and Tax Design

Abstract

This paper develops a new policy response to the growing problem of complexity in business taxation: a Pigouvian excise tax on complex entity structures. Because enforcement resources are limited, complexity in firms — even compliant ones — dilutes the effectiveness of enforcement, creating social costs: lost revenue, unfair distribution of tax burdens, and inefficient allocations of capital and labor.

The problem is most acute in complex partnerships, which are widely used by investment firms to minimize tax but are notoriously difficult to audit. Despite reporting over $1.4 trillion of income annually — more than a third of all US business income — partnerships are rarely audited on account of their complexity; in 2020, individuals earning under $25,000 were seven times more likely to face audit than a partnership.

The proposed solution is to impose an excise tax based not on income or wrongdoing, but on observable indicators of complexity that increase enforcement costs and thus weaken enforcement. By doing so, the tax causes firms to internalize the social cost of complexity. The approach improves efficiency by discouraging complexity when it is not socially valuable, while still allowing firms to adopt complex forms when doing so generates sufficient value to justify its costs.

The paper offers a concrete implementation tailored to partnerships, featuring administrable check-the-box criteria and a broad economic base derived from existing return data. Also, a general equilibrium model formalizes how complexity distorts tax enforcement and resource allocation, and demonstrates that taxing complexity can outperform conventional tools like increased penalties or audits alone.

Author

• Michael Love, Columbia Law School