The term moral hazard gets thrown around a lot these days, and I must confess it's a hard concept for a dim bulb like me to understand. Thankfully, I finally came up with a simple definition (hat tip to Nicole Kurokawa, a senior policy analyst with the Independent Women s Forum, who influenced my thinking). Moral hazard: What happens when the government provides bad incentives that lead to bad outcomes. If you want an obvious example of a moral hazard, look no further than our bloated, unfair and inefficient federal tax system. Here s what I mean.

My personal copy of the Internal Revenue Code is now over 4,000 pages of very fine print, and it s growing rapidly. The table of contents alone is 237 pages. I kid you not! Add to that many thousands of pages of IRS regulations and guidance that attempt to explain (often futilely) how the rules Congress enacted are supposed to work. Then there are many more thousands of pages of court decisions dealing with disputes about how those rules are supposed to work. In the last 26 months, Congress passed 13 pieces of legislation with tax changes important enough for me to write about. If not for the gridlock caused by health-care reform efforts, there would be three or four more new tax laws to sift through. (Rest assured they are still in the pipeline.) What hope does an individual or small-business owner have of keeping up with all this ever-changing complexity? None.

The point is, there s an excellent chance that your tax return is wrong. Your employer s return is almost certainly wrong, and the returns of all your friends and neighbors are probably wrong, too. So what happens if the politicians order the IRS to go on an audit rampage? Almost everybody the feds decide to look at will be found to have something wrong with their returns. Say hello to assessments for additional taxes, penalties and interest, along with lost time, professional fees and all that.

Now let me inject a little justifiable paranoia into the discussion. What happens if the selection of audit targets becomes a politically-motivated process? You can t be happy with a system that provides such a powerfully bad incentive to those who might be tempted to use it for nefarious purposes. It s a moral hazard just waiting to happen.

The System Encourages Fraud

From the taxpayer s perspective, out-of-control tax complexity encourages individuals and businesses to throw up their hands and fill out their returns in ways that result in them paying what they feel like paying instead of what they actually owe. This is one reason why government estimates of increased revenues from tax hikes almost never pan out. Taxpayers can cover their unwillingness to pay with perfectly believable claims that they simply didn t understand the rules. Done on a grand enough scale, this is tax fraud. When you make the rules so complicated that even the most honest taxpayers can t fully comply, it s a moral hazard.

Even worse, our system is riddled with so-called refundable personal tax credits. For example, say I file a return showing I m eligible for the refundable $8,000 home buyer credit even though I never bought a home and have never paid a dollar of income tax in my whole life. By going to the trouble of filling out a couple forms and filing them with the IRS, I get an $8,000 check from the feds. That s the refundable credit concept: free money for filling out forms. Just so you know, a recent study by the Treasury Inspector General for Tax Administration uncovered about 100,000 apparently fraudulent home buyer credit claims after a quick look at some 2008 returns, and I'm sure that was only the tip of the iceberg. One "taxpayer" was four years old. I'm not making this up! Good luck tracking down the credit fraudsters and getting back the money they stole (from you). The same thing can happen with other refundable credits such as the earned income credit (it has a long and sordid history of fraudulent claims), the child credit, and the new American Opportunity education credit. When you give away free money in exchange for turning in some paperwork, you re asking for fraud. It s a moral hazard.

Not only that, laundering welfare payments through the tax system by calling them refundable credits is anything but transparent. We can argue the merits of welfare programs, but let s first call them what they are instead of calling them tax incentives. Lack of transparency is a moral hazard.

The System Puts Corporate Welfare Up for Sale

Do you think it s outrageous that Hollywood film studios qualify for a special tax break that was advertised as being for manufacturing companies and that big drug companies get a huge tax incentive for locating plants in Puerto Rico instead of the United States? So do I. Do you think NASCAR race tracks deserve tax goodies not allowed to other businesses? Neither do I. Welcome to corporate welfare disguised as tax breaks. I can give you dozens of examples that illustrate what showing up in Washington with bags of cash can buy. If you want to know for sure which industries have the best-funded and most politically connected lobbyists, just check out the tax code. It s disgusting. It s a moral hazard.

The Last Word

When guys like me who make a living from dealing with taxes start complaining that the system is so convoluted, broken, and corrupt that it's become a moral hazard, alarm bells should go off in your head. The sad truth is, we have the tax system we deserve. We have not paid enough attention to what is being done in our names in Washington, so we are where we are. We won t get a simple, fair, and efficient tax system until we demand it. So far, we have not -- but hope springs eternal.