Saturday, December 16, 2017

Apparently income isn't just income any more

The group of us that published the "Tax Games" piece is hard at work drafting a follow-up that preliminarily evaluates the extent to which the sorts of problems that we identified with the House and Senate bills have been addressed, ignored, or worsened under the conference agreement. To be honest, several others in the group are much harder at work on it than I am at the moment (I'm in Munich in the aftermath of a quite interesting, interdisciplinary international tax conference at the Max Planck Institute), but I will try to chip in as well.

I will post the link here when it's available, hopefully soon. We have an aim of posting it before the bill is voted into law, in part lest anyone in Congress whose vote isn't entirely pre-committed might actually care about what the legislation does. (No, we are not deluded about the probabilities in this respect, but if we weren't idealistic we wouldn't be bothering with this to begin with.)

But I wanted to follow up here on a point that I mentioned in my last post, and that was brought to my attention by co-authors (who were looking at the bill while it was the middle of the night here in Munich).  It pertains to the special exclusion in the passthrough provision of architects and engineers from the list of personal service businesses that automatically can't, past a specified income level, take advantage of the special 20% deduction for passthrough income.

When the House was initially drafting the passthrough rule, there was a provision excluding business owners who worked in personal service businesses from claiming the special low rate. Now, this never made sense from the beginning. There was some sort of a clumsily mal-expressed intent in the House bill to separate out pure labor income a bit, and deny it the benefits of the special rule, apparently on the view that it was kinda like employee wages.

Now, this never actually made any sense. Capital income already was effectively exempted under the bill due to expensing, and so the special rate was really for labor income that was intermingled with capital income. It was a way of giving, say, real estate, oil and gas, retail, manufacturing, etc., lower tax rates than doctors, lawyers, and such. (Plus, the idle business heir who is busy skiing in Gstaad gets the special rate.) So I wouldn't call it very principled even if there was a sort of woolly rationale lying underneath.

Even the House bill really did amount to saying that work - labor - wages in the economic sense - would get lower tax rates in some businesses than others, for no reason beyond Congressional favoritism. But one could imagine that someone imagined they were drawing a coherent line of some kind for some reason. Hence, for example, the absurdly misguided attempt to deny the full benefit to people who were materially participating under the passive loss rules - arguably aimed at implementing the underlying idea, badly confused though it was, that this was somehow about lowering the tax rate for capital income rather than labor income.

If one squinted at it that way, one could almost see a rationale for excluding the personal service businesses that would be sincere to a degree, even if fallacious and incoherent. But how to define personal service businesses that would be cordoned off (subject, of course, to their playing games such as renting buildings to themselves)? Easy, they found a list in an existing tax statute that had defined personal service businesses for a wholly different purpose, and that does actually look like a good faith effort to draw up a comprehensive list, including most of the obvious candidates and then with a catchall phrase at the end for the rest.

Not only doctors, lawyers, athletes, consultant, etc., but also architects and engineers, were on this list. But then something happened in conference. They decided to strike architects and engineers from the list of personal service businesses for purposes of determining eligibility for the 20% passthrough deduction. No explanation offered, so far as I can see.

Here's an illustration of what this means in practice. A doctor and an architect are both in the 37% bracket. Each then earns an extra $100,000.  The doctor pays an extra $37,000 of tax. The architect manages to structure the receipt as qualified business income that gets a 20% deduction. Hence, the architect has only $80,000 of extra taxable income and pays only $29,600 of extra tax. The doctor's marginal rate is 37%, the architect's is 29.6%.

There is no whisper of a rationale for this. They had a list of personal service businesses that they didn't make up themselves, and even if using it didn't make sense to begin with, at least they were just plugging it in, as it stood. Now two favored professions have been taken off the list, apparently because someone with influence over the final product wanted to benefit architects and engineers relative to doctors, lawyers, athletes, consultants, etc.

As it happens, they may have bungled this effort to exclude architects and engineers, through incompetent drafting. The personal service business exclusion still applies to "any trade or business where the principal asset of such trade or business is the reputation or skill of one or more of its employees or owners." (The words "or owners" were newly added in the conference version.) Wouldn't that generally apply to architects and engineers? But they certainly seem to have meant to take out architects and engineers, and even with the bungled drafting - no doubt, just one of dozens or even hundreds of examples, if one carefully read the bill as a whole - that might influence its interpretation by the Treasury, IRS, and courts. So let us credit them with deliberately taking out architects and engineers, on the view that they should have a lower tax rate than doctors, lawyers, consultants, and athletes, without prejudging how this bungled drafting job is actually best interpreted.

This is in effect industrial policy, although we haven't as yet learned why Congress should use the tax code to direct business activity away from medicine and into architecture and engineering. But of course to call it industrial policy would verge on granting that there was an underlying policy aim, however misguided. (Does someone think that there are negative externalities to healthcare and/or positive ones, under-compensated by the market, that are particular to architecture and engineering?) On the other hand, corrupt explanations, at least in the colloquial (as distinct from legally punishable) sense, come readily to mind.

This gets to why I titled this blog post "Apparently income isn't just income any more." Congress appears to be moving towards creating lists of professions and businesses that should get higher versus lower tax rates. It's not just a matter of, say, more favorable cost recovery rules in one profession rather than another. Now actual labor income (with sufficiently well-advised structuring) gets different marginal tax rates, depending on whether it's earned in a business that Congress likes more, or one that it likes less. And this is completely ad hoc and decided on in secret, without even a statement of broader underlying rationales. A dollar isn't just a dollar - its tax rate depends on whether and how much Congress likes the relevant trade group.

I put a marker down early in the game, when I said that the passthrough rules looked like the worst provision ever even to be seriously proposed in the history of the federal income tax. I'm feeling increasingly vindicated as the legislation proceeds through Congress, and I anticipate (without pleasure) that this feeling will only grow as we see the provision play out in practice across real time.

Conference agreement on the tax bill

At a quick initial glance, in some ways the final version of the tax bill makes the gaming potential of the passthrough rules even greater than before. For example, they have expanded the ability of partnerships et al that can jam some property ownership into the business to claim large tax benefits even without having many employees.

They've also decided that architects and engineers, unlike all the other "personal service business" types such as doctors and lawyers, can now get full benefits from the rule. The arbitrariness of this exclusion helps to underscore how corrupt and unprincipled the entire process of developing this legislation in general, and the passthrough rules as a particular example, has been. This truly is incoherent industrial policy, reflecting fundamental disrespect for a free market economy, as well as for neutrality, transparency, and public oversight.

On the bright side for lawyers, there will be millions of dollars in legal fees devoted to devising and implementing brand new tax avoidance strategies (and not just in the pass-throughs rules, of course). Law firms are going to need to hire additional tax lawyers to work on all this.

Wednesday, December 13, 2017

Another perspective on the passthroughs

Mark the Knife posted a comment on a prior blog post of mine in this series. As I found it perceptive, I hope he doesn't mind my pasting it in here:

The push for a passthrough tax seemed based on some sort of odd understanding by members of Congress regarding "fairness" between passthrough businesses and C corps. I think there's a sense that corporate E&P is (ignoring the fact it isn't really "income") capital income par excellence, and income from passthroughs which is like E&P should receive the special rate.

So if I were to say what the theory behind the guardrails is intended to be, it's: If this passthrough were a business operating as a C corporation, would a particular allocation of income be retained (or allowed to be retained) in earnings and profits? If so, it deserves the special rate. Else, it should get the regular rate.

You can then see the two bills as focusing on a different problem--the House hates that labor income could be disguised as "E&P-like" income, and the Senate is aimed at attacking passthroughs that are the equivalent of corporate pocketbooks (a sort of personal holding company rule, but one that determines classification by looking to employment by a holding company instead of its income).

I don't think this is a terrific theory by any means, and certainly each bill deviates in some way from this theory, but it's my best shot at a cohesive theory thus far.

(Back to me): This strikes me as a very plausible account of how some of the thinking might have developed. Unfortunately, as grounds for policy it's incoherent nonsense (as I suspect Mark the Knife would agree).

A C corporation's E&P is kind of, very roughly, its "capital income" if not swelled by underpayment of salary to owner-employees. In a pure public company where only deductible compensation is paid to employees who lack significant owner interests, it's kind of a match for capital income, defined as the residue after paying labor costs, only it may include rents that a consumption tax would reach, not just normal returns that it would exempt. If you're using expensing to exempt the normal return, why exactly do you need to also have a low tax rate here? This was one of the points about the DBCFT - in principal the rate could be high without driving out capital a la an origin-based corporate income tax.

Now we go to the passthrough setting, and supposedly equity as between different types of entities - a nonsensical concept since (a) only people matter and (b) passthrough owners can incorporate - dictates also giving a low rate to the passthrough income that's left after paying out salary. Only, here we are very far from the setting of a publicly owned company in which owner-employees may only own a smallish piece. In the classic passthrough, a small group of owners has the whole thing, and has little need to pay themselves salary as that's just moving money between pockets of the same suit. So they all underpay themselves labor income, at least once the new law is in place, and they want a lower rate because - well, just because.

Mark the Knife's final nice point goes to the House versus the Senate having different aims. Apparently Ryan et al hate lawyers and such more, while in the Senate maybe they hate ?? more? (Not quite sure who they're after or why.)

I guess we'll see what comes out in conference, but we can be sure that it will still have no coherent rationale.

Tuesday, December 12, 2017

The passthrough rules versus consumption taxation

My last two blogposts addressed the incoherence of the passthrough rules, and their having no discernible underlying policy rationale (even one that is wrong) that can be stated at a more general level than "liked by the Congressional Republican leadership."

Let me put the same point in another way. Do the Congressional Republicans agree that a pure, full-fledged consumption tax, which is often described as exempting "capital income," would adequately address the pro-growth aims that the passthrough rule supposedly has?

A pure consumption tax is supposed to hit all consumption equally. It's economically equivalent to a wage or labor income tax, if those terms are defined broadly enough, leaving aside transition issues and the like. And such a tax, of course, taxes all labor income the same. (It may have graduated rates for a particular individual, as may a progressive consumption tax that is applied at the individual or household level, but that's a different point.)

The passthrough rule, by contrast, is premised on taxing some labor income at lower rates than other labor income. And despite some gesturing towards favoring the use of capital - from the disfavoring of personal service businesses, and for that matter the House bill's half-baked set of rules about electing your ratio of capital in the business - that is what it does. It taxes some labor income more favorably than other kinds, while also favoring rentiers (in the House bill) so long as they own businesses rather than owning financial interests in businesses that yield nonbusiness interest and dividends. (Yes, that's exactly as coherent as it sounds.)

The terms capital and capital income are not 100% clear, so one could define rents (extra-normal returns) as part of capital income if one likes, although my old friend David Bradford always used to say that in some sense they have got to be labor income. But he would agree that we're getting into semantics here. And there is no coherent principle that I can imagine, including those that I would disagree with, under which rents should be specially tax-favored. If anything, they can be taxed more highly without discouraging people from reaping them.

So if the passthrough rules ostensibly are in some way concerned about using capital, but they make distinctions and provide special tax benefits that would be unavailable in a system that exempted capital income, what exactly is the intent here?

I think the best one could do with this question, but I don't know that it can really be treated as a part of legislative intent, is to think about it as follows. A lot of the Congressional Republicans seem to believe that some people - the "job creators" et al - are superior to other human beings. They should be rewarded for being superior. And given their superpowers, this is bound to benefit the plebes somehow, someway. (Although why do they need the special tax breaks if they have such superpowers?) So they see some people, who may to an unsurprising extent overlap with their donors (or themselves before they entered politics) and say that these superior people, these Ayn Randite benefactors of all humanity, should be rewarded for their superiority by paying taxes at lower rates.

I can almost imagine a Ryan or Hatch saying: I don't know how to define these people in the abstract, but I know them when I see them.

This of course is not only anti-democratic and anti-egalitarian, but also anti-free market, insofar as it ends up distorting economic activity since we can't label the favored ones innately but only by observing what they do &/or report for tax purposes. But it's the best I can do at trying to define the subjective intent, whether or not the cognizable legislative intent, that underlies the promulgation of these rules (insofar as it is not simply crass and corrupt).

An added thought about passthroughs: is it supposed to be about having "employees"?

In my last post, I inquired into what "guardrails" might mean, in the context of the passthrough rules, given the lack of any underlying theory for who gets the benefit and who doesn't. But a further thought that occurs to me is, are the rules trying to incentivize having employees?

Evidence in favor of discerning such an intent might be that having employees may potentially make it easier to avoid materially participating under the House bill, and that the Senate bill in some settings limits the benefit to 50% of one's wages paid. And maybe the thing is about encouraging the growth of businesses that will provide jobs (?).

But here's an odd aspect of the passthrough rules, even at the level of "theory" (scare quotes because it's rather kind to say that there's a theory at work here). I'm being encouraged by the passthrough rate to run a business with employees instead of myself being an employee. But the people I might hire as employees are being encouraged to do the same thing, rather than being my employees. So for people who are actually weighing the choice between these two models - and note, of course, that it can be a purely formalistic choice via the claim of being an independent contractor, etc. - it seems to contradict itself. An employment relationship takes two to establish, the hirer and the hiree. One is being pushed towards it, the other is being pushed against it (other than being pushed merely not to call it an employment relationship).

Anyway, having employees doesn't do a great deal of work under the provisions, as a formal matter, anyway. In the House bill, you maximize your benefits by avoiding material participation, which is very different from hiring vs. not hiring, or hiring more vs. fewer people, or hiring employees rather than independent contractors.

In the Senate bill, the wages-paid "guardrail" (if that's what it is) can be met by my paying wages to oneself. E.g., say I earn $100,000 through a business that I'd like to get the 23% deduction for qualified business income, but it's just me. Not to worry, I pay myself $32,000 of reasonable compensation wages. Now my qualified business income is $68,000, and I can deduct 23% of that ($15,640) so long as it doesn't exceed half of the wages ($16,000). So I get the full 23% deduction, which, if my marginal tax rate is 38.5%, saves me $6,000 of tax for no obvious reason.

In sum, the idea of having employees, which ostensibly might relate to a policy rationale of encouraging job growth, doesn't do much to add the coherence to the passthrough rules that they would need for one to figure out what the "guardrails" are supposed to keep out.

What does it mean to have "guardrails" if there is no underlying theory of who should get the benefits and why?

I've been thinking about the issue of "guardrails" in relation to the passthrough rules in the House and Senate bills, with regard to whom they are supposed to keep out.

The problem I'm having in thinking about it is that, since there is no coherent underlying theory regarding who should get the benefit and why, it becomes difficult to figure out who would be getting it "improperly," and contrary to legislative intent, if we require defining such intent at a more general level than "industries that are friendly with the Congressional Republicans."

Let's take the underlying question of how the special rate for passthroughs relates to labor income, or wages in the economic (as opposed to the legal) sense. Wages in the legal sense don't get the special rate, but is it supposed to be for people who are providing labor income (even if combined with the use of capital) in the economic sense? Note that labor income in this sense, of course, extends to thinking about how to run the business, making decisions about its possible expansion, etc.

Both the House and the Senate bills appear to gesture in the direction of trying to reduce its association with doing work. But they do so ineffectively. The House bill has the supposed guardrail of reducing the benefit if you materially participate as defined by the passive loss rules, which would mean that the mere idler who owns a perhaps inherited business and trusts the hired hands to run it does better than the one who actually works.

But what's the reason for rewarding the idler? Doesn't it have something to do with decisions we think this person is making, which again is a form of work?

Note, BTW, that the passive loss rules were written to dampen the use of claimed managerial oversight as a mechanism for establishing material participation. But if you go back to the 1986 legislative history of the passive loss rules, you will see that this was based on a concern that people could fake exercising managerial oversight that was actually de minimis. (E.g., you just rubber-stamp whatever the folks whose business it actually is tell you to rubber-stamp.)

Then there is the exclusion in the House bill for personal service businesses. I have tended to interpret this as just reflecting that the House Republicans aren't particularly good friends with lawyers, doctors, consultants, etc. They are better friends with the real estate industry, the oil industry, etc. But there's a fig leaf on it of trying to sort out what's purely labor income - except that the people in the favored industries really have predominantly labor income too, at least if one defines it in the economic sense and they are actually running their businesses (not skiing in Gstaad while daddy's henchmen run the business).

We get to the Senate bill, and the personal service industries get some moolah from the provision until one's taxable income gets too high. And one doesn't get the special rate for W-2 wages that are actually paid, so long as they are reasonable compensation. But there's no requirement that one pay reasonable compensation - one can underpay oneself and get the passthrough deduction so long as one otherwise qualifies. So it taxes labor income favorably, so long as you aren't stupid enough (or constrained by liquidity concerns) to pay it to yourself as formal wages.

The whole thing also really has nothing to do with taxing "capital income" at more favorable rates than labor income.  The way to lower the tax burden on capital income, relative to a pure income tax, is to have expensing or its equivalent, not to tax interest income or the normal return, etc. The tax bills do this to a degree, e.g., by allowing a lot of expensing (plus interest deductions to make some capital income affirmatively subsidized rather than exempt!), although they don't exempt interest income.

But the favorable rate for passthroughs really has almost nothing to do with any of this. Again, those businesses are getting expensing, and if they're getting extra-normal returns (rents in economic lingo), without which all this becomes less interesting, then taxing these returns is efficient.

So one main aspect of the passthrough rule is a special, lower tax rate for labor income when it's done through a passthrough, the definition of which is pretty much circular (you qualify if you qualify, and it's hard to see why in terms of an underlying theory). Plus, Junior at Gstaad gets the special rate, reflecting others' past labor income that presumably is continuing to play out nicely, and again it's not quite clear why.

Against this background, what exactly is the guardrails' proper reach? It's quite hard to say when the underlying theory in support of the rules is so lacking. By lacking, of course, I mean not just incorrect but incoherent or nonexistent.

Monday, December 11, 2017

Double taxation, non-taxation, and regulatory clean-up under the House and Senate tax bills

I've often commented, in the realm of international taxation, that focusing on "double taxation" can be a suboptimal way of understanding the tax burdens being imposed. E.g., I'd rather be taxed twice on the same income at 5% each time, than once at 35%.

But "double taxation" rhetoric can sometimes identify settings where the overall marginal rate might seem, upon closer examination, to be unduly high.

Now, in the Republican tax bills, we get "double taxation" via the disallowance of state and local income tax deductions. Again, that alone just means one should look more closely, rather than showing that it inherently must be bad. But it is surprising that the "double taxation" framework has been so little mentioned, given the common practice of decrying estate taxes as potentially leading to "double taxation" of income that was taxed when earned and then might be taxed again when it's transferred at death (albeit, of course, that the estate tax runs off value, not gain from a prior value).

So if one is "double-taxing" income via denial of the state and local income tax deduction, one should take extra care that combined tax rates don't go too high. But if there is anything at all that the Congressional Republicans are not doing as they rush these tax bills through, it's take care.

Now Richard Rubin has a nice article showing that the phaseout of passthrough benefits for certain professionals, plus taxes in a state like New Jersey can yield marginal rates, for certain taxpayers and in certain ranges, in excess of 100%. In other words, earn more and you end up with less.

Meanwhile, allowing complete non-taxation - zero ever (at least federal) on potentially unlimited amounts of income that one earns - appears to be a bedrock principle of both bills, despite its being rather hard to justify.

To my knowledge, a 2015 House bill offered the first instance in the history of the U.S. federal income tax in which a proposal to eliminate the estate tax was not accompanied by proposing curtailment of section 1014, the tax-free step-up in asset basis at death. But that was just a for-show exercise, given that President Obama would be certain to veto the legislation anyway. Now, in 2017, they've done it again, and apparently for real.

In 2001, by contrast, deferred repeal of the estate tax WAS accompanied by rule changes to make sure that people who had untaxed appreciation, and who now wouldn't be facing the estate tax, would at least not get the basis increase as well, and hence would not be able to eliminate permanently the prospect of any federal tax on huge gains.

Say I bought a Renoir painting for $1M, and due to the run-up in the art market its value has gone up to $100M. Under the House bill, the accretion and the value will never face any federal income or estate tax liability if my kids sell it after elimination of the estate tax. Under existing law, the same thing happens under the income tax, but at least the estate tax offers a kind of back-up (and anti-"double taxation" arguments have been deployed in support of the income tax result).

Some people thought that getting rid of the estate tax without addressing basis step-up, being so unprecedented and hard to justify, must just be an accidental glitch. But then the Senate bill substantially scaled back the estate tax without doing anything about it either. This despite their scrambling for revenue at the end, so they could purport to make the overall target. This suggests that it must have been deliberate. (And it's not hard to see why if one thinks in terms of what the donors would like.)

In sum, as the bills now stand, in certain very standard situations, there can be marginal tax rates in excess of 100% for some people, and of 0% for others.

One last bit about allowing the tax-free basis step-up at death is that it hugely increases the attractiveness of using corporations as a tax shelter through which one can pay just a 20% rate on both one's labor income and one's investment income. If the second level of tax is merely being deferred, the gambit may become significantly less appealing. But with a lower tax rate today, plus no tax in the future if you play your cards right, it's another way of having tax rates decline as one moves up the income scale (since the wealthy can more easily arrange this). And again, after what we've seen from both houses, I can only presume that this is an intended effect.

Will the Treasury attempt to address some of the worst tax planning gambits in the tax legislation, in cases where it can be argued that a given gambit must have been unintended? It's hard to say. What was intended will certainly be up for grabs here. Plus, if the IRS and Treasury leadership address enforcement in the same spirit that, say, the EPA reportedly does, you could have a setting where aggressive tax planning gambits, yielding untoward results, that arguably could be addressed through regulatory provisions and/or auditing, will deliberately be left alone, by policymaking fiat from up high.

Saturday, December 09, 2017

There is no reason why

Patricia Cohen, in today's NYT, has a nice piece discussing the pass-through rules. It's called "Tax Plans May Give Your Co-Worker a Better Deal Than You."

Opening paragraphs:

In most places, a dollar is a dollar. But in the tax code envisioned by Republicans, the amount you make may be less important than how you make it.
Consider two chefs working side by side for the same catering company, doing the same job, for the same hours and the same money. The only difference is that one is an employee, the other an independent contractor.
Under the Republican plans, one gets a tax break and the other doesn’t.

The article then explains the rule's regressivity, its penalizing being an employee for no known reason, its treating some professions more favorably than others for no known reason, and its strong inducement to artificial tax planning.

Somewhere in the middle, it quotes me as saying that the House version "might be the single worst proposal ever prominently made in the history of the U.S. federal income tax."

In fairness to the negative merits of the Senate version, it hadn't at that point been developed yet, so I couldn't compare the two.

I think any fair-minded reader will agree that the rest of the article, both before and after my quote, offers a lot of support for my statement. We think of the tax system as aiming to address efficiency, equity, and simplicity. The passthrough rule, in either version, unambiguously makes all three worse.

There is no rationale for the provision. To move towards equalizing passthroughs' tax treatment with C corporations? But C corporations face a second level of tax. Plus, business owners can simply incorporate if they like, without its inconveniencing them in any significant non-tax way.

For job creation? The chef who gets the low rate is a job creator, and the other isn't? Qualifying for the lower rate has no link to job creation.

It involves second-guessing of the market, based on what theory of market failure it isn't entirely clear. Why not let pretax prices guide appropriate investment and labor choices, as happens with neutral tax treatment? It's incoherent as industrial policy.

What defenses have been, or can be, offered for it? There really are none. Jared Walczak of the Tax Foundation is quoted as saying that the provision might make sense theoretically in a vacuum. But I take him to agree with me that the actual proposal is bad, as he follows this up by noting that it's difficult to distinguish between wage income and business income. I would add that it doesn't even make sense theoretically or in a vacuum.

Business income IS wage income insofar as it reflects the labor of the business owner. Anything else that we want the owner to do, such as reinvesting or whatever, can be addressed via rules aimed at that particular activity (e.g., expensing for capital investments, which the bills have on top of the passthrough rules).

What if employees save, and the bank loans the money to people who want to found or expand their businesses? That has less merit, because the Republicans in Washington know more than the capital markets?

The article mentions that the proponent's "idea is that these [the pass-through] businesses will reinvest those higher returns and stimulate growth."

If that's the goal, stimulate investment! Or is this actually just a call for redistributing money to people whom it is thought have a greater marginal propensity to invest? Then why not just give more money to rich people, without running it through the passthrough structure?

The balance of the article then gives us a taste for all the incredible "job creation" that the passthrough rules will ostensibly encourage. E.g., "staff lawyers on salary suddenly turn into partners" so they can get the passthrough rate. High-earning dentists do better still by becoming C corporations that are taxed at 20%. (The tax bill has no guardrails for that either.)

Friday, December 08, 2017

The Sex Pistols and tax "reform"

A reporter with whom I was chatting earlier this week about the problems with the pass-through rules asked me: Yes, but there must be reasons for having the rules, aren't there?

I replied: "To quote the Sex Pistols, 'there is no reason why.'"

I evidently assumed he meant reasons other than funneling giant tax savings to donors.

The Sex Pistols quote comes from their great anthem EMI, an exhilarating explosion in which they almost seem to accept leadership of a movement, despite all the positivity that would imply.

The reporter was surprised (although perhaps he shouldn't have been) to hear a law professor quoting the Sex Pistols. He said he might try to use it, but apparently it didn't fit in. So I trust I'm not scooping him here.

And so it goes, and so it goes, and so it goes, and so it goes. But where it's going, no one knows.

More games they might play

Here's some more that just occurred to me, and that I don't believe we included in The Games They Will Play. My apologies to anyone else who may have published about this already - I'd link, but haven't seen it.

Suppose a high-priced consultant of some kind produces memos, and/or creates videos embodying the advice. (Nothing fancy, just talking into the camera from one's desk.) Or suppose at least that the business could be done this way.

Might we now, with appropriate structuring, have sales of property (the memos and videos) by a pass-through business that deals in property, rather than the personal service business of consulting?  This is not about capital gains treatment (where it's an old issue, and where one would need to meet the holding period requirement to get the long-term rate).  It's just to take the thing out of being a personal service business, not one that sells property, for purposes of the pass-through rules.

If the consultant also still communicates his/her conclusions via conversations with the clients, do we need price allocation between the consulting payments and the sale of property?

And here's another, although it's probably more of a stretch. If the consultant works at home, and also rents the home out via AirBnB, might we have a business of  making money through use of the home in multiple ways, and hence that uses capital? Again, existing rules address versions of this type of admixture (e.g., the rules limiting home office deductions), but the idea here is different; it's just about changing categories in the pass-through rules.

Thursday, December 07, 2017

Newly published report on taxpayer game-playing under the Republicans' tax cut act

I am among the thirteen signatories of a report thas has just been published online, entitled "The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation."

Many thanks are due to the report's lead drafters, who were Ari Glogower, David Kamin, Rebecca Kysar, and Darien Shanske. It draws on many people's analyses, including not just that of other signatories, such as me, but also numerous non-signatories who have helped to advance the rushed public conversation.

Evidently, the notion of public service, based on caring disinterestedly about the tax law's quality and effects, isn't dead in the tax academy and the tax bar, even if it appears to need a respirator up on Capital Hill.

Here is the report's Executive Summary:

This report describes various tax games, roadblocks and glitches in the tax legislation currently before Congress.

The complex rules proposed in the House and Senate bills will allow new tax games and planning opportunities for well-advised taxpayers, which will result in unanticipated consequences and costs. These costs may not currently be fully reflected in official estimates already showing the bills adding over $1 trillion to the deficit in the coming decade. Other proposed changes will encounter legal roadblocks, that will jeopardize critical elements of the legislation. Finally, in other cases, technical glitches in the legislation may improperly and haphazardly penalize or benefit individual and corporate taxpayers.

This report is not intended as a comprehensive list of all possible problems with the drafting and design of the House and Senate bills. Rather, this report highlights particular areas of concern that have been identified by a number of leading tax academics, practitioners, and analysts.

In particular, the report highlights problems with the bill in the following areas:

Using Corporations as Tax Shelters

If the corporate tax rate is reduced in the absence of effective anti-abuse measures, taxpayers may be able to transform corporations into tax-sheltered savings vehicles through a variety of strategies. For instance, at the most extreme, it may be possible to shield labor income in a C-corporation so that it faces a final tax rate of only 20%.

Pass-Through Eligibility Games

Taxpayers may be able to circumvent the limitations on eligibility for the special tax treatment of pass-through businesses. For instance, under the Senate bill, many employees—such as law firm associates—could become partners in new pass-throughs and potentially take full advantage of the special tax treatment.

Restructuring State and Local Taxes to Maintain Deductibility

The denial of the deduction for state and local taxes will incentivize these jurisdictions to restructure their forms of revenue collection to avoid this change. This could undercut one of the largest revenue raisers in the entire bill.

International Games, Roadblocks, and Glitches

The complex rules intended to exempt foreign income of domestic corporations from U.S. taxation present a variety of tax planning and avoidance opportunities. For instance, one provision would encourage sales of products abroad, only for those products to be sold right back into the United States. Furthermore, several of these rules are likely to be non-compliant with both World Trade Organization rules for international trade and our network of bilateral tax treaties. Some of these rules also create perverse economic incentives, like advantaging foreign over domestic manufacturers.

Arbitrage Money Machines

The variety of tax rates imposed on different forms of business income in different years invite arbitrage strategies, whereby taxpayers can achieve an economic benefit solely based on the timing and assignment of their income and deductions.

Other Glitches

Other glitches in the proposed bills would haphazardly penalize taxpayers. For example, the reintroduction of the corporate AMT at the 20% rate in the Senate bill would vitiate key tax incentives and the basic structure of the international reforms. The proposal in the House bill to tax capital contributions to entities could penalize taxpayers for no justifiable reason.
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Again, the report is available here.

Monday, December 04, 2017

One way to improve the tax bill (although it would still be awful)

My view of both tax bills that now await a conference is that they combine making revenue and distribution much worse with reducing the efficiency of the tax system and greatly increasing its complexity for high-income individuals, who will be absolutely swimming in new tax planning opportunities. It also represents a historically unprecedented use of the federal income tax system as a targeted weapons system for distributing favors to friends (beyond just using "rifleshot" special exceptions for one or two taxpayers, although we have those too) and, let's call it less favorable treatment for non-friends.

That said, there is one way that one aspect of the harm could be made less bad, although they won't be taking me up on this. A clear goal of the legislation is to ensure that special friends among the super-rich pay lower marginal rates than people in the upper middle class. I wouldn't dignify this with the label of "belief about fair distribution," since, for example, high-paid CEOs of publicly traded companies don't appear to be in the special friends group.

The aim, rather, is that very rich people they like, in industries they like, should pay lower marginal rates than those in the upper middle class or the less-favored super-rich.

But let's suppose they were willing to generalize, in a more principled way, their belief that very rich friends should pay lower rates than people in the upper middle class. Suppose they were willing to apply this belief to all very rich people, on a neutral basis within that group.

Then there would be a mechanism for reducing the tax bill's inefficiency and encouragement of tax planning, without doing any overall harm either to revenue or to distribution.

It would be a simple four-step process: (1) eliminate the passthrough rules, (2) address the use of corporations as a tax shelter, via the under-payment of owner-employee salaries and the "stuffing" of corporations with investment assets, (3) eliminate the tax-free step-up in basis at death, which greatly worsens lock-in for appreciated assets and ensures that huge profits enjoyed at the top will never be taxed at all, and (4) lower the top rate as much as you can given these changes, without sacrificing overall revenue or changing overall distribution. We might then have an overt, and perhaps significant, decline in marginal tax rates at the top.

This would eliminate the inefficient industrial policy and inducement to ridiculous tax planning that the current structure has, without making either revenue or distribution any worse than they are already. It would also amount to an honest statement of the actual distributional policy that evidently motivates the tax bills, insofar as there is a policy beyond that of rewarding donors and friends. And, for what it's worth, it would avoid treating the super-rich unequally (special friends better than the rest).

It would be interesting to know just how much rates at the top could decline in this scenario. But we know they won't do it, for at least 3 reasons: (1) lack of concern about the structural and tax planning problems that the bills are causing, (2) a preference for dishonestly concealing the actual distributional policy (hence all the lies about this being a "middle class tax bill"), and (3) the fact, that among the super-rich, they want to direct the largesse at their special friends in particular.

Saturday, December 02, 2017

Calling all tax "leasing" experts


Today's magic word of the day, if the final tax bill has either of (a) the lower pass-through rate (it will) and (b) the one-year corporate rate cut delay (who knows), is LEASING. There will be a lot of "leasing" going on, take my word for it.

UPDATE / CLARIFICATION: A friend has forwarded to me an interesting analysis of the tax bills' effect on equipment leasing, which has pluses and minuses that are still unknown given uncertainties about the final legislation. Limiting interest deductibility, for example, could worsen the tax analysis of equiment leasing in some scenarios.

I didn't mean to address, in the above comment, how actual leasing in the economy would be affected by the tax legislation. Leasing in that sense is a finance method for particular actual & substantive transactions, and I haven't attempted to analyze how it works out against other methods. Obviously there may be tax reasons for using leasing, rather than something else, as one's formal structure, but (at least in the standard case) it's a function of actual business deals, typically involving new investment.

What I meant by "leasing" in the above, and the reason I used scare quotes, is because I meant to refer to pure tax planning transactions - such as:

1) One's left hand "leasing" something to one's right hand. An example would be a law firm, under the House bill's passthrough bills, forming a real estate partnership to lease the building to the service partnership,

2) Sale-leasebacks to transfer title to taxpayers that can better use the expensing deductions, and

3) Under the Senate bill, the use of leases and subsequent sale or purchase option to take maximum advantage of the 35% corporate rate in 2018 versus the 20% rate in 2019.

In sum, leasing may or may not be helped by the tax legislation - but "leasing" WILL be helped.

Friday, December 01, 2017

What could a reasonable Republican-ish tax reform have looked like?

Now that the tax bill is temporarily paused due to deficit issues - although I'm still expecting it to go through, and probably sooner rather than later - it's a good time to ask, not so much what went wrong as what could have gone right, at least in an alternative universe where our political system was better-functioning. And in particular, I'm thinking of an alternative universe in which, say, the beliefs of reputable conservative economists, rather than reputable liberal economists, had particular influence with policymakers. (I say this due to a number of legitimate disputes about good policy that I will mention without trying to resolve here.)

The lesson of the actual process, alas, is that bad people with bad motivations, acting in haste to avoid deliberation and accountability, are going to do bad things. Also, being ignorant seems to have some disadvantages. But even so, some of the ideas they started with, and which are to a degree in the proposed legislation, would have at least arguable merit if done differently.

One more bit of throat-clearing here: I think we academics have learned something about business tax reform - or. to avoid that loaded and misused term "tax reform," desirable business tax changes that respond positively to changed circumstances since 1986.

My sense of the predominant consensus among us several years ago is that it viewed the corporate (or business) and individual levels as too intertwined for one to be changed significantly without also addressing the other.  But then some of us got impatient. The business level of current U.S. income taxation is so bad, the view grew, that can't we do something about it without waiting for the whole thing to improve?

In principle, this view could be either right or wrong. It's a judgment call. Obviously addressing the whole thing would be better, but might it still be worth trying to hit a double instead of a homer?

I am thinking that the answer has turned out to be: No. A key problem I (and others) had with the destination-based tax was that doing it apart from addressing the individual side threatened to cause real problems. But politics has also strengthened the case for No.

The movement for a lower pass-through rate, which (as I've argued in earlier blog posts) might end up being the single worst structural change in the history of the U.S. federal income tax, shows how politically intertwined the corporate/business and individual levels are. But in an earlier version of the problem, people came to realize that paying for lower corporate rates through income tax-style base-broadening would hand the pass-through sector a huge tax increase that, whether or not it was good policy, was certain to be politically unfeasible. Same problem from the opposite angle.

OK, getting at last to this blogpost's title, what could a reasonable Republican-ish tax reform have looked like? Here are some main points:

1) Lower corporate headline rate, with base-broadening offsets. But note two different types of offsets: those that simply get rid of industry-specific tax breaks, and those that make our system more of an income tax and less of a consumption tax. It's easier to reach intellectual consensus in favor of the former than the latter. But doing just the former wouldn't pay for much of a rate cut at all, on a revenue-neutral basis that ought to have remained the target given long-term fiscal issues.

Lower still, thus losing revenue? Maybe, if there are alternative revenues sources - e.g., VAT or carbon tax. (The key to the destination-based tax, of course, is that it tried to smuggle in a VAT by calling it something else.) But if the corporate or business rate is lower than the individual rate, and you still have an income tax at the individual level, a bunch of further steps are desirable. One is to try to limit the extent to which the benefits of the lower rate reach old investment. It should just be for new investment. But the politics on this are backwards - inefficient transition gain is exactly what the donors want.

Also, if the corporate or business rate is lower than the individual rate, one should think about shifting more taxes to the owner/shareholder level, and also about addressing the use of corporations as a tax shelter via the underpayment of taxable compensation to owner-employees. (The lower passthrough rate gets this completely backwards - extending preferential rates to labor income of owner-employees, despite the supposed guardrails, and despite the second level of corporate tax, and thereby inflicting punitive relative treatment on employees plus insoluble line-drawing problems.)

2) Move towards expensing - Once again, there is dispute about this. E.g., just limiting it to my past or future Tax Policy Colloquium co-teachers, Alan Auerbach vs. Lily Batchelder. But there is a case for expensing, so long as it's accompanied by sufficiently addressing interest deductibility, so taxpayers can't get a net subsidy by combining consumption tax treatment of the outlay with income treatment of the interest expense.

But implementation of expensing, when there is still an income tax at the individual level, requires further thought about the coordination between business and individual taxes. Plus it causes big problems when tax rates change.

I've been pointing this out with reference to the idiotic Senate Republican proposal to start expensing in 2018 and the lower corporate rate in 2019. (Hence, deducting $100 in 2018 at the 35% rate, in order to earn $90 in 2019 at the 20% rate, makes money after-tax.) But it's a much broader and more general problem. Indeed, I gather that the Senate Republicans are struggling with the other side of it right now, as businesses have complained to them (making a conceptually correct point) that they would lose from expensing outlays at a 20% rate and then including the returns at, say, a 22% rate.

3) International - Here there is actually a bit of free money available, in an efficiency sense. (Not free politically or distributionally, however.) Two aspects of it. First, deferral makes no sense whatsoever. I have long called it a "ceasefire in place" between the warring pro-worldwide and pro-territorial viewpoints. No one with any sense favors deferral; the issue is "compared to what." Immediately taxing US companies on their foreign profits at the "correct" rate is unambiguously better than deferring the tax, which would then ultimately depend on the tax rate in the repatriation year plus the value of foreign tax credits.

But what is the correct rate? Oops, that's the hard part, and I certainly don't mean to rule out the possibility that, at least in some instances, it might be zero. Due to the complex nature of the underlying issues, which I've tried to unpack (without resolving definitively) in a number of academic articles, we don't know what the correct rate is, or how it should vary with particular details of the foreign source income that is at issue. (E.g., what is reported as tax haven vs. other income.) A further problem is that there's no clear consensus about the optimal amount of profit-shifting by US and foreign companies that are operating in the US. It's not necessarily zero, since they may be more mobile than other businesses. That undermines figuring out how rigorous the anti-profit-shifting rules should be, especially if some of our tools work better against US than non-US companies but we don't inherently want to treat the two differently.

Still, the problems with international deferral means that something better ought to be possible. Plus, it is clear that a deemed repatriation of past earnings that US companies have stashed abroad would not only raise revenue (within the budget window, no less) but be desirable in efficiency terms. E.g., it reflects past decisions, and might reduce the anticipatory incentive to engage in further future profit-shifting that exceeds what we determine is the optimum.

So that's in a sense free money in budgetary terms, except that the rate imposed could in principle be too high, plus the companies aren't going to like it unless the rate is very low.  (If too low, it's in effect another repatriation holiday even if mandatory. After all, a mandatory deemed repatriation is equivalent to a voluntary holiday for anyone who would have taken advantage of the holiday anyway.)

Obviously this falls far short of saying what a principled Republican-ish tax reform could have looked like. But it could have had a lower corporate rate, properly addressing the difference between corporate and individual rates, a new revenue source,, something more like expensing but with reduced interest deductibility and due sensitivity to tax rate changes, and something in international, where there are reform plans out there that could have been consulted.

Sounds pretty vague, I know, but with good people who cared about governance, a year or two of bipartisan deliberations might have led to something that principled conservative economists could endorse without descending to dishonest hackery, and that principled liberal economists could agree had significant merits even if they would do some of it differently.

Thursday, November 30, 2017

Broader political economy lessons of the tax bill

I have been assuming for some time now that some version of the horrible tax bill is bound to go through, probably within a week or two. After all, it is not as if any significant number of Congressional Republicans (and it would only take three of them in the Senate) appears to care in the slightest about how it would affect people other than their donors. Even the so-called "moderates" in the Senate, like Collins and Murkowski, readily accept "assurances" from Trump that they cannot be stupid enough to believe. They just want deniability or a fig leaf. I suspect the same holds for the supposed "budget hawks" such as Flake, whom I would guess - despite his not facing reelection - will ask no more of the "trigger" than that it qualify as a visible if irrelevant gesture. Likewise, while others have noted the significant remaining differences between the House and Senate bills, it's not as if anyone on either side actually cares enough about the substance, or real world effects, to let the bill die over mere trivialities such as whether 13 million people will lose their health insurance.

There may of course be political ramifications, such as electoral danger for House Republicans in blue states from repealing state and local income tax deductions (although the most electorally vulnerable may be freed to cast ineffectual votes against it). But the underlying theory is either pluto-populism - you buy enough support from the donors to unleash a blizzard of ads on racial and "cultural" issues - or else that, even if political payback is coming, you might as well do it while you can.

A broader lesson, beyond the mystery of why the Republican Party - it's not just Trump - seems to have completely rejected notions of responsible or informed governance, which did matter to its leaders in the 1980s - is that, at least when money has unchecked reign in politics, it causes the government's redistributive policy over time to have an anti-insurance feature.

Rising high-end inequality that has adverse social consequences for everyone else ought to trigger policies aimed at scaling it back. But instead, because it increases the relative political and economic power of those at the top, it is self-reinforcing. Greater high-end inequality triggers the adoption of policies that further increase high-end inequality, triggering the adoption of policies that still further increase high-end inequality. It's a positive feedback loop.

One further broader lesson is as follows. Political scientists for decades followed the so-called "rational voter" model, in which people voted in favor of their economic interests. But the model is basically false. One of its main problems (although there are many others) lies in the voting paradox. Given how unlikely it is that my vote would change the outcome, it would be decidedly irrational for me to spend any time figuring it out and voting that way. So even if I do vote, it must be for other reasons and reflect other impulses. To use a favorite illustration, how much time would you spend figuring out what is the best car for you to buy (if you're not inherently interested in cars) in the scenario where you had only one vote, among millions, with regard to which car you would actually get?

An important recent political science book, decisively rebutting the misnamed (because irrational) "rational choice" model of voting, is Christopher Achen's and Larry Bartels' Democracy for Realists: Why Elections Do Not Produce Responsive Government.

In such a world (i.e., our actual world), responsible governance depends less on voting, or on politicians' electoral self-interest as ostensible agents on behalf of their constituents, than on the ideology and value structure that the elites happen to have. Donors are obviously a big part of this, but not all - a lot, I think, lies in the mysterious black box realm that I will just call culture or values or sources of prestige because I don't have a more definite handle on it at present.

Thus, the fact, which I really don't understand and can't fully explain, that at least since 1994 Republican elites - though, obviously, not all conservative intellectuals - have increasingly and acceleratingly gone mad is at the core both of what ails us more broadly as a society, and of the apparent (I think) near certainty that a horrible, harmful, and recklessly irresponsible and sloppy and thoughtless tax bill is about to be enacted.

Of course, I could (I hope) be wrong about the tax bill, although not (I fear) about the rest.

Tuesday, November 28, 2017

Perhaps it figures

The Senate is currently working on its version of the most plutocratic and fiscally irresponsible federal tax legislation in U.S. history.  Also probably the sloppiest and most poorly designed ever. (I can vouch for this going back to 1981, and before that the nature of the process probably prevented this sort of malfeasance.)

Nonetheless, as McConnell hunts for 50 votes, the impetus, as the New York Times reports, is to make it more plutocratic still. Senators Johnson and Daines are demanding larger tax benefits for passthroughs, which supposedly - but not actually - are treated worse than C corporations in the bill. More on that in a moment.

Buying Johnson's and Daines' votes would definitely cause the legislation to be both more plutocratic and even more poorly designed. The passthrough provisions don't, and as a matter of basic design really can't (especially in the abbreviated timeframe) have even remotely adequate guardrails. They are a tax lawyer's Full Employment Act for all sorts of tricks that I have discussed in prior posts, and I suspect that I am just scratching the surface.

Whether giving more goodies to passthroughs would also make the legislation still more fiscally irresponsible depends on how they do it. Johnson and Daines propose taking at least some of the lost revenue out of the hides of C corporations, via repeal of the state and local (income?) tax deduction for such companies. This actually is not entirely lacking in rationality, if one takes it as given that state and local income taxes shouldn't otherwise be deductible, but it's a hard sell optically, plus it would further undermine state and local governments along the same lines as repealing the deduction for individuals. (But that's a separate debate.)

C corporations are probably right to be a bit nervous here. Apart from the insistence on giving them a 20 percent rate and territoriality, they are, as Willy Loman would have put it, liked but not well-liked by Congressional Republicans. It's the super-rich pass-through owners who are well-liked. And while there is clearly an immense willingness to do harm to middle-class and poor taxpayers, for the former at least there are concerns about the political optics.

In any event, as I noted above, it's also false that the passthroughs (or more precisely, their owners) are being treated worse than if they operated C corporations. We know this for a very simple reason: they would simply restructure to be C corporations if they thought that would benefit them.

Some of them are already incorporated under state law, and have simply elected to be taxed as S corporations (which are treated as passthroughs). And even for the rest, there is really no significant business reason not to do this. They don't even have to use states' corporate law statutes, since other flexible entities, such as limited liability companies (LLCs) can readily serve as C corporations for federal income tax purposes, with just minimal planning.

Why wouldn't they want to do this? Well, the reason TO do it, obviously, is to get the 20 percent corporate rate, in lieu of the higher passthrough rate that even the House bill offers. But then they would face the second level of tax, upon receiving corporate distributions. The tax cost (or tax-induced inconvenience) of doing that offers the only credible reason why they wouldn't choose to incorporate.

The argument is therefore being made in bad faith, whether or not Senators Johnson and Daines (who are not generally considered the Senate's two leading tax minds) are aware of this.

Here's a further amusing snippet, from Richard Rubin and Siobhan Hughes in the Wall Street Journal, concerning Johnson's arguments for additional passthrough rate cuts:

"Mr. Johnson said the rate disparity ... would cause pass-throughs to change their legal status and become traditional corporations. He said that would cause revenue losses that congressional estimators haven't accounted for; it wasn't clear Monday what those estimates assumed."

It's unclear how (or if) Johnson thinks this can be reconciled with his claiming that the passthroughs are disfavored. But it's actually plausible that if passthrough owners did convert, this would cause revenue losses within the period being measured by the official score, even if the present value of their tax liabilities increased (except, in that case they presumably wouldn't convert to begin with). The second level of tax might often be incurred after the close of the estimating period, and the forecasts aren't infinite-horizon.

Another way of putting this is that conversion to C corporation status might be less bad fiscally over the long run than within the ten-year estimating window. But, from the standpoint of what Johnson is trying to argue, he's still trapped in nonsense. They're not disfavored if they can readily convert, and if they don't want to convert then they're evidently not disfavored even under their current organizational form as passthroughs.

Monday, November 27, 2017

Unfortunate news for NYU Law School

My colleague Joshua Blank is leaving NYU for UC Irvine Law School, as detailed here. This is very unfortunate, both from my personal standpoint and for NYU Law School institutionally (as well as personally, both for my colleagues and for scores of our students who have come to know him). But it's great news for UC Irvine, and I know that Josh will thrive there.

Wednesday, November 22, 2017

54th anniversary of the JFK assassination

A friend noted on Facebook that November 22 is still "the most memorable of all dates for some of us."  He quotes Mary McGrory as saying, at the time, "We'll never laugh again," to which Patrick Moynihan replied, "No, we'll laugh again. But we'll never be young again."

I was in my first grade classroom when the assassination happened. The teacher was called out of the room to hear something on the radio, which seemed very odd and unprecedented. Then we got the news, which verged on unfathomable for a group of middle class New York City 6-year olds. The Oswald shooting, which came a couple of days later then added a touch of yet further previously unimagined grotesque madness.

I nonetheless certainly still felt young for a long time afterwards, and I have laughed plenty since, albeit not about what happened on 11/22/63.  Yet for me, and I know for many others in my age cohort, it was the first major crack for us in what one might now call the era's Leave It to Beaver edifice. But this now seems as if it ought to have been particular to people who were as young at the time as we were.

I was too young, as of 11/22/63, to know anything much about World War II or McCarthyism, or to have much understanding of what was going on with, say, the civil rights movement or the early stages in the lurch towards U.S. involvement in the Vietnam War. So it really was a first hint that the world was more scary, dangerous, and chaotic than those in my age cohort, living in similarly benign and sheltered circumstances, had been led to assume. But, without belittling the immense immediate emotional impact of the tragedy, weren't the likes of McGrory and Moynihan old enough to have seen plenty of dark and horrible things before?

Third time's a charm?

I've done multiple versions of talks, using slides, that discuss the destination-based cash flow tax - a proposal that (despite my respect for and friendship with its leading academic proponents) I consider greatly overrated conceptually.  The fullest version of the slides is here, but a more recent (though shorter) version is here.

When I say the DBCFT is overrated conceptually, I mean that it's really just a VAT (with a couple of extra features) in lieu of the existing entity-level corporate income tax - based on the sometimes undefended, and clearly erroneous, assumption that one can only have one or the other, not both. Discussing it tends to obscure or crowd out properly focusing on the issues it actually raises - such as whether the origin-based corporate income tax rate should actually be lowered all the way to 0%, what with the individual income tax generally remaining in place (and serving some desirable purposes, even if imperfectly). So my critique is distinct from, albeit hardly incompatible with, arguing that the DBCFT oughtn't to be enacted - a question that cannot really be answered properly until one has done more to specify the rest of the surrounding fiscal system.

Because the DBCFT, unlike its forebear David Bradford's X-tax, isn't embedded in a system that also specifies how individuals are generally taxed, it reflects a failure to address one of the most biggest questions, which is how to integrate it with the rest. And sometimes less is less, not somehow more.

My skepticism has certainly influenced my titles. The first version was called: "The Rise and Fall of the Destination-Based Cash Flow Tax: What Was That All About?" The second was called "A Requiem for the Destination-Based Cash Flow Tax."

They say (never matter who "they" are) that the third time's a charm. And, as I've been asked to discuss the DBCFT in a conference at Munich next month, I've been working on a new version, to be posted after that conference, currently called "Goodbye to All That? A Requiem for the Destination-Based Cash Flow Tax." Yes, the degree of originality in the titles appears to be declining precipitously.

But also, I've decided (I think) to write up a textual version of those slides that will appear in a conference volume sometime next year, presumably after showing up on SSRN with a link that I'll post here.

Monday, November 13, 2017

110th Annual NTA Conference on Taxation

From Thursday through Saturday, I spent an enjoyable if hectic stretch of time at the National Tax Association's 110th Annual Conference on Taxation, which this year took place in Philadelphia. I stayed overnight even though NYC is close by, hence I guess cue the W.C. Fields jokes ("Last night I spent a weekend in Philadelphia").

I always enjoy going to the conference, both intellectually and socially. One gets to hear about a smattering of current research (I focused on international tax and tax "reform" panels), and to meet old friends or (less commonly at this point) make new ones who are in the "biz" whether as economists, lawyers, government folk, or practitioners.

My own direct involvement, apart from moderating a panel, consisted of presenting a shortened (by more than 50%) but also modestly updated version of my slides discussing the destination-based cash flow tax. In deference to events since I gave the earlier version of this talk, I call the new version "A Requiem for the Destination-Based Cash Flow Tax."

The earlier version remains available here.

I wasn't exactly a winner in the scheduling for this talk. It ended up in a far-off room that one pretty much needed a compass plus trail mix to find. Plus, the other two papers on the same panel were quite different from mine. One discussed the incidence effects of sales tax holidays, while the other discussed tax-favored tobacco sales by Indian tribes. Both were quite interesting and good, but the common ground with my talk wasn't enormous.

This is not, in the slightest, meant as a complaint! I know how hard it is to schedule all the panels and talks, as Tracy Gordon and I shared this same job a few years ago. I am certain that we inadvertently did the same or worse to lots of people,* because this is simply inevitable when you are scheduling dozens of panels. Not all of the papers will fit together into unified panels, and not all of the panels can get the best locations. In consequence, as a presenter, you win some and you lose some.
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*Indeed, I also remember - and here the fault was definitely mine, not Tracy's - inadvertently rejecting all three papers by a given author, even though they were interesting and good, due to a screw-up in the course of deciding which one of the three to accept. I was able to correct this error when I discovered it in the course of looking for commentators on other papers.

The Tax Arbitrage Act of 2018?

Tax arbitrage, as the term is used in the literature, involves having offsetting long and short positions that are taxed asymmetrically.

In a "pure tax arbitrage," as Eugene Steuerle first (to my knowledge) dubbed it in 1985, the taxpayer has perfectly offsetting economic positions that may pair, say, deductibility of the payout with excludability (or at least deferral) for the receipt. A classic example is the Knetsch case, decided by the Supreme Court in 1960. Here the taxpayer purported to borrow and lend the same $4 million from the same insurance company counter-party. But he "borrowed" at 3.5% and "invested" at 2.5%, leading to $140,000 of accrued interest expense and only $100,000 of accrued annuity appreciation per year. So he'd write the company a $40,000 check for the difference and deduct $140,000 of interest. (Black letter law at the time unambiguously supported both the deduction and the exclusion, leaving aside economic substance doctrine).

In a regular tax arbitrage, the positions aren't perfect offsets. Hence, they may not be arbitrages in the way that finance people use the term, but they are still tax arbitrages. For example, if you borrow to hold non-dividend-paying stock, deducting the interest while deferring the offsetting appreciation, this would give you a tax arbitrage, even though you have a net position (e.g., bad news for you if the stock market plunges). However, the tax juice from this little game is addressed by the investment interest limitation, which generally limits deductions for investment interest to net investment income.

There would be no tax arbitrages under a pure Haig-Simons income tax that was consistently applied. But when there is a hodge-podge of different rules for different types of items, some of it becomes inevitable. A whole host of special rules in the Internal Revenue Code try to limit it in one setting or another. These rules add complexity if one defines it simply as the number of pages of tax law, but they may actually reduce complexity in practice if they sufficiently discourage taxpayers from going to great (or any) lengths to arrange tax arbitrages that would siphon money out of the Treasury to no socially or economically valuable end.

Asymmetric substantive rules are one way get to the creation of tax arbitrages that serve no good purpose. Having at least some of this is inevitable once you have a realization-based income tax. But the creation of pointless tax arbitrages becomes even easier for taxpayers, if one allows them to pick and choose between alternative marginal rates for the income and/or loss from the same activities.

It's amazing to me to what extent the House and Senate versions of tax "reform" pointlessly create huge tax arbitrages of this kind. The proposed special rate for pass-throughs, a key feature of both bills, has the potential to become the single greatest inducement to tax arbitrage ever enacted by a single Congress.

And of course I have been noting here how the Senate Finance Committee's idea of expanding expensing immediately while delaying the corporate rate increase by a year, creates a massive tax arbitrage loophole. As per my prior post, it is economically equivalent to providing 175% expensing - i.e., allowing deductions of $1.75 for every $1 the taxpayer spends - for 2018 only. Spending a dollar to earn a dollar, but getting to deduct $1.75 while only including $1, is a classic tax arbitrage example.

If I were willing to lengthen this post still more, I could explain in detail a further tax arbitrage that is possibly more important than the ones I have been emphasizing. The bills combine allowing expensing for new investment with partially retaining interest deductibility, and the literature has shown that this allows the creation of tax arbitrages that can drive the effective tax rate for new investment below 0 percent (i.e., to amount to a net payout from the government even if the investment offers a pretax return of zero).

Given these egregious problems in the bills, I am thinking that the Republicans should relabel what they are doing the Tax Arbitrage Act of 2018.

They may not have fully realized this, but it's an inevitable byproduct of trying to craft multiple rates that can apply to the same taxpayer and (with requisite planning) to the same offsetting outlays and receipts.