Friday, December 22, 2017

Fun for the holidays?

Despite my often writing articles and even a book about international tax policy, I've been a bit remiss so far in my degree of focus on the international rules in the tax bill. They're complicated and so is thinking about them, I wanted to make sure they were final so I wouldn't waste time on proposals that disappear, and I've been focusing on other aspects such as the passthrough rules.

Plus, I have other academic writing interests that, at the moment, grab me a bit more. My book about literature and high-end inequality is # 1 in this regard, but I'm also writing a short paper about the destination-based cash flow tax on a short time fuse.

That paper will be based on the various versions of slides that I've posted in the past, such as here, but it will be much more focused on the academic literature than on last year's Republican House proposal, which I would presume is politically dead. My main point is that academics should move on from it, too - it's a multi-instrument package, and each of the instruments is worth taking seriously, but the packaging serves no good purpose and should be dropped, as it only confuses even experts who should know better.

A couple of months ago, I wrote a first draft of a short international tax paper, which I haven't posted or submitted anywhere. It's now partly obsolete due to the new 2017 tax bill. But that's actually a good thing, even from the comically self-centered standpoint of a writer with sunk costs. I felt a bit bored at times writing the piece, not always a recipe for one's best work (although I think it has some good features), and I now have something fresh to put into it, i.e., responding to the new international rules in light of the framework that I use in the piece, which is based on my past international work.

So I have given myself homework for the holidays, in the form of printing out the international provisions in the final bill and conference report (I'm still old-fashioned enough to prefer paper for non-casual reading that is long-form), plus a few associated items that will help me think about them. And I plan to take more of a deep dive over the next couple of weeks than I have so far.

My initial sense of the international tax rules in the final bill is that they are less bad than the other features I have been discussing. That's a pretty low bar, of course, when one has been thinking about the passthrough rules. But a couple of points in favor of the new international rules, compared to the bill's worse elements are:

1) They started from what everyone agrees is really bad present law. (By contrast, the passthrough rules gratuitously screwed up something that was previously working fine, i.e., the absence of any such rules.) This inevitably affects a fair assessment of whether they have made things worse. Case in point, they've created incentives to move assets abroad, but under present law one may already have such incentives.

2) One thing that's distressed me elsewhere in the bill is frequent lack of concern about tax avoidance, where that's defined as taxpayers getting favorable results that don't follow from a good faith policy aim. Case in point is not trying to limit exploitation of the 21% corporate rate by personal service corporations and the like. People incorporating so they can get the low rate for their labor income is NOT part of any reasonable rationale for lowering the corporate rate in response to international tax competition. Then, in the passthrough rules, while they make some effort to limit the ability of some service professionals to take advantage, the whole thing is so unprincipled to begin with that I've noted that I can't see what the concept of undue tax avoidance even means there, unless one defines it as people and industries that the Republicans like versus those that they don't like.

International is different. The extent to which they wanted to address tax avoidance seems clearly to have been greater than zero. Whether it's adequate or well-executed is another question, but at least we are starting here from a higher baseline.

I also note that they seem to have at least gestured towards, and perhaps even implemented to a degree, a couple of ideas that I have been pushing in international tax policy debate. The first is steering away from what I call a 100% MRR (marginal reimbursement rate) for foreign taxes paid. Foreign tax credits that are allowable immediately are only one mechanism for having a 100% MRR in practice. Global "minimum tax" rules can also have this effect, as can anti-base erosion rules in some settings where they focus either directly or indirectly on shifting foreign income to tax havens.

A second idea that I've been pushing, and that I believe the bill reflects (but will have to study it more carefully) is that one's base erosion rules shouldn't over-rely on domestic residence.  Prior U.S. international tax law, even if it did too little overall about base erosion, did too much of what it did via the subpart F rules, which only apply to U.S. companies with foreign subsidiaries. The ability to have controlled foreign corporation (CFC) rules, like our subpart F, for domestic companies but not foreign companies means that one can do more to address (and fine-tune one's addressing) base erosion by the domestic than the foreign. This creates a tradeoff, in that one may want to take advantage of the extra tools where one can, but there may otherwise be no reason to treat the residents worse than the nonresidents. Again, there appears to be some of this in the new rules, perhaps reflecting the political ease of going after foreign relative to domestic multinationals.

Some of the biggest defects in the new international rules may be multilateral or strategic. Obviously there is the treaty issue that Rebecca Kysar has been writing about, and that we discussed in both Games 1 and Games 2. Plus there are strategic issues: even insofar as doing X benefits the U.S. unilaterally - i.e., in the case where it doesn't change what anyone else does - what if other strategic players actually do respond to us? The prospect of both imitation and retaliation can affect how we think about taking a given step, keeping in mind that the question here is how others change what they do by reason of what we did.

So there's a lot for me to think about, but I do think I will end up sounding more measured, simply because a measured (even if in some respects critical) response seems more likely to be deserved.

Anyway, if I can bear to read all this stuff over the holidays - and, if not, I'll do it in early January - then I will have some updates on what I think about it, eventually I'd presume in academic writing but initially here.

Thursday, December 21, 2017

New doggerel, inspired by the tax act?

There's a bit of old doggerel that I remember from Kurt Vonnegut's Slaughterhouse Five, that goes something like this:

My name is Yon Yonson
I live in Wisconsin
I work in a lumberyard there
The people I meet when I walk down the street
Ask my name and I say:
My name is Yon Yonson
I live in Wisconsin
I work in a lumberyard there

In the aftermath of the 2017 tax act, I think we are ready for a new version. But I am still working on the fifth line.  Here's what I have so far:

My name is Ron Johnson
I represent Wisconsin
My millions from passthroughs are there
The people I meet when I walk down the street
Ask which senator threatened to vote against the tax bill unless tax benefits for passthroughs were               expanded, and I say:
My name is Ron Johnson
I represent Wisconsin
My millions from passthroughs are there

The Act with no name

Here is the start of the 2017 tax bill, taken from the Conference Report:

Sec 11000. SHORT TITLE, ETC.
(a) SHORT TITLE.-This title may be cited as the "Tax Cuts and Jobs Act."
(b) AMENDMENT OF 1986 CODE.-Except as otherwise expressly provided, whenever in this title an amendment or repeal is expressed in terms of ... a section or other provision, the reference shall be considered to be made to a section or other provision of the Internal Revenue Code of 1986.

Why am I bothering you with this? Just bear with me here for a moment.

Here is the start of the 2017 tax bill, taken from the final enrolled act:

Sec 11000. SHORT TITLE, ETC.
(a) AMENDMENT OF 1986 CODE.-Except as otherwise expressly provided, whenever in this title an amendment or repeal is expressed in terms of ... a section or other provision, the reference shall be considered to be made to a section or other provision of the Internal Revenue Code of 1986.

There is no section 11000(b) any more, and old (b) has of course become (a).

So what happened in the interim? They took out the bill's title! It has no name now! (But there are still later statutory references to the Tax Cuts and Jobs Act, even though this has ceased to be a defined term.)

I specifically looked for this omission, when I got an electronic copy of the final bill, because I had heard that the Senate parliamentarian made them strike the name as a non-germane amendment.

This means absolutely nothing substantively, but perhaps I can be forgiven for finding it hilarious. They were in such a heedless rush that the bill ended up without a name! Of course, it doesn't deserve a name.

Wednesday, December 20, 2017

From the Munich conference on international tax policy that I attended last week

I'm in the second row, two to the right of the spot near the center where, for color contrast reasons, the eye most naturally travels. I'd like to claim that I'm taller than I look here, but I suppose that is not an inherently promising line of argument.

Here's a "dynamic" effect of the 2017 tax bill that we CAN expect to see

As I've noted in prior posts, one thing the tax bill does is strongly encourage non-employees to incorporate their businesses, including personal service businesses, and pay tax at only 21% federal. Even if they end up paying a second level of tax upon withdrawing their funds, there is almost no downside. And if they don't need to withdraw the money directly, they may never end up paying that second level of tax. And Congress openly invited this result by providing that the tax rate for personal service corporations will be 21%, or the same as the general corporate rate.

Suppose a lot more people incorporate than the Joint Committee on Taxation anticipated when it scored the legislation. Then the overall revenue losses will be even bigger than the JCT predicted. But "corporate" revenue will be higher than forecast, due to the unanticipatedly high shifts.

One thing you can be certain of, if this happens: proponents of fake and overstated "dynamic" scoring will cherry-pick this number, and claim that it vindicates them. In short, an oversight that loses revenue will be treated by them as evidence that tax cuts actually do raise revenue. Of course, this requires staying tightly focused on corporate revenues, not overall revenues, but I am sure that this constraint will prove no difficulty.

Any good academic study of the revenue effects of the 2017 bill will, of course, take this issue into account. But competent and good-faith academic studies are not what I am talking about here.

UPDATE: BTW, this point was made to me by the WSJ's Richard Rubin. Didn't want to mention him by name without his approval.

How to gain under the budget rules from sloppy drafting

Everyone knows how unconscionably rushed and sloppy the Republican tax bill was.  What's gotten less focus is how the ineptitude of the process may pay future budget-rules benefits to the Republicans.

Suppose we start from the bill's estimated $1.4 trillion ten-year cost (ignoring for now the "dynamic" issues that the Joint Committee thought might lower it to $1 trillion - although better estimates by analysts with greater independence from political pressure show less offset than this).

Now suppose that two drafting errors or omissions, triggering massive tax avoidance responses that the JCT did not anticipate, turn out to have 10-year budgetary costs of $100 billion each.

Suppose that Blunder #1 goes to people the Republican leadership likes, such as business owners who take unexpected unadvantage of the lower corporate rate, fun and games with passthroughs, etc.

All they have to do is leave this in place, and they get to shower $100 billion more on their friends, who will be duly grateful, without its ever appearing in a revenue score.

Now suppose that Blunder # 2 goes to people the Republican leadership doesn't like, such as blue state professionals who end up, one way or another, getting the equivalent of extra state and local income tax deductions due to countermeasures that they and their state legislatures develop.

Say this triggers "technical corrections" to take away the extra $100 billion that people have figured out how to save in taxes, via gaps and mistakes in the original drafting.  In effect, this retroactively causes the original revenue estimate for repealing the deduction to be correct after all.  Only, the Congressional Republicans get budgetary credit for a $100 billion revenue increase that would have been denied them, had they drafted the bill more competently upfront. And there's no sort of budget-rules offset for the fact that the 2017 revenue estimate, based on what was actually enacted, ought to have been $100 billion higher, purely as a matter of logical consistency. So upfront incompetence is potentially all upside for these guys.

Monday, December 18, 2017

Intended upside-down marginal tax rates?

If high-income "business owners" manage to use aggressive tax planning that ensures they will pay lower tax rates than many of their own employees under the tax bill, is that a feature or a bug? The more closely you look at the Republican tax bill, the more it looks like the former - i.e., as something that is consciously intended (albeit hidden, to a degree, from clear public view).

A case in point that I have in mind is the personal service corporation (PSC) rules. These rules, which have been in the Code for many years, seek to limit the tax benefits that service providers, if they are independent contractors rather than employees, might otherwise get from incorporating.

For example, under present (pre-2017 bill) law, one might think of incorporating one's personal service business in order to lower one's marginal tax rate from 39.6% (the top individual rate) to 35% (the corporate rate), as well as to avoid the 2% floor that applies to certain "miscellaneous itemized deductions," etc.

Now, at present this is a fairly small-bore game. One generally tends not to save a whole lot of tax liability, and one subjects oneself to the potential of facing two levels of tax, since withdrawals that aren't within "reasonable compensation" may be taxed as dividends. So the main thing that the PSC rules now do is force one to face the full 35% corporate rate on even the first dollar of one's PSC income, rather than getting the rate graduation benefits that current (pre-bill) law offers to smaller corporations.

Under the pending tax bill, it seems clear that the drafters, if they were acting in good faith as defined by their stated premises for the legislation, would have wanted to think seriously about using the PSC rules to go after bigger game. After all, the tax rate difference is now quite large - 21% corporate versus 37% individual - and even with the second level of tax there is almost no possible downside to earning one's income through a PSC rather than directly (at least, once one's tax rate gets far enough above 21%).

Plus, one would think that the main rationale for the 21% corporate rate was global tax competition, along with the idea of treating returns to saving more favorably than under present law, in the hope of increasing investment. Neither rationale applies when someone is using a PSC to lower the tax rate on his or her earnings from the provision of personal services.  Thus, the use of a PSC, although perfectly lawful, could readily be defined as having the potential to yield unintended tax avoidance if tax policy was being made in good faith (as defined above).

In the House bill, they actually made the PSC rate 25%, as opposed to 20% for C corporations generally. But apparently even that was too harsh for the Senate to tolerate. So there they made the PSC rate the same as the general C corporation rate.

In conference, the House "receded" (and I suspect it didn't fight very hard). So the PSC rate in the bill is 21%, just like the C corporation rate generally. Let the tax games begin!

Now, it is true that this is formally consistent with the approach taken under prior law, in the sense that there, too, the PSC rate equaled (rather than exceeded) the general corporate rate, and the 35% rule served only to eliminate use of the lower corporate rate brackets by PSCs. (Lower-tier corporate rates are now gone.) But this is not what Congress would have done if it had meant to confine the benefit of the lower corporate rate to instances where the public rationale for it actually applied.

This is a real tell (as they say in poker). It suggests that the bill's proponents are comfortable, and perhaps even affirmatively happy, with an upside-down rate structure under which business owners will frequently pay lower tax rates than the people who are working for them. I suppose one could call this "Kansas justice," in honor of Sam Brownback.

Under the conference bill, as soon as your taxable income reaches $45,000 if you are single, or $90,000 for a married couple, your marginal tax rate rises to 25%. Starting in 2018, there will be a whole lot of incorporated "business owners" who will be paying lower marginal tax rates than many of their employees.

New DBCFT slides from Munich

I just got back earlier today from Munich, where I attended an interdisciplinary conference at the Max Planck Institute for Tax Law and Public Finance, entitled "International Tax Policy in a Disruptive Environment."

My presentation at this conference was entitled "Goodbye to All That?: A Requiem for the Destination-Based Cash Flow Tax." I've at least twice given prior versions of this talk, which in one instance (a longer but earlier version) I posted on SSRN here.

The latest version of the slides, which I gave at Max Planck last Friday, can be found here.

I am planning to write up an actual article version of the talk, for publication in a conference volume. I will probably be ready and able to publish it in SSRN by the end of January. I'm hoping it will be interesting - I have some criticisms to voice of the DBCFT as an analytical construct.

The games they will play, part 2

Our little group, led by David Kamin, and with Ari Glogower, Rebecca Kysar, and Darien Shanske as his fellow main writers, has now posted "The Games They Will Play: An Update on the Conference Committee Tax Bill."

It's available here, while Part 1 remains available here.

Sunday, December 17, 2017

Under the new tax bill, lose money before tax but make money after-tax

Our revised Tax Games report should be out within a day or two. (The original is still here.)

But one hallmark of the new tax bill that I want to highlight right here and now - because, in the new report, it will be just one of very many things that we will be pointing out - is the incentive to engage in transactions that reduce one's tax liability, even if these transactions lose money before tax.

A quick prediction - there will be many billions of dollars worth (at least as reported for tax purposes, although many of them may be quasi-fake beyond the paper-shuffling) of such transactions. The opportunities to make money after-tax - in effect, to drive large trucks right up to the Treasury vaults and start siphoning out loose cash - are simply too great. People will have manifold incentives to do things that lose money before-tax, due to the larger after-tax savings that they will see they can reap.

One obvious example pertains to people who pay tax at a 37% marginal rate, but who can engage in transactions with companies they own that pay tax at only a 21% marginal rate. Set the tax lawyers and accountants loose, and there will be plenty to do along this margin.

But here's another - the passthrough rules. Say I earn $100X through a passthrough, but am temporarily blocked from claiming the full 20% passthrough deduction (i.e, up to $20X) because I don't have any W-2 wages paid or capital assets through the business.  But I can deduct the $20X so long as it doesn't exceed (a) 50% of W-2 wages paid by the business (including to myself), or alternatively (b) the sum of 25% percent of such wages paid and 2.5% of the original cost basis of tangible assets used in the business.

Case 1, pay a new employee $20X, in the expectation that this will increase my gross revenues by $15X.  I am down $5X before tax, but my taxable income declines by $15X, since I can now deduct an amount that is up to half of the wages, or $10X.  Result: at a 37% marginal tax rate, I reduce my tax liability by 37% of $15X, or $5.55X.  So I am $5X behind before tax, but $.55X ahead after-tax.

Case 2, I buy a machine for $100X, fully debt-financed. I get to expense this and claim an immediate $37X reduction in tax liability, but let's ignore that here since a full analysis would require dealing also with the back end, where I repay the debt and might have recapture income (and/or a pretax loss from the purchase plus disposition). While it seems to me that there is rich tax gaming potential here, given its requiring a fuller analysis let's ignore it for now, and just focus on the annual cash flow.

Say I pay 8% annual interest on the loan, and earn $7X per year from using the machine.  Since I (or rather my attorneys) are not fatally dim or inept, I can deduct the entire annual interest expense, without worrying about the tax bill's interest deduction limits. Even so, I am $1X per year in the hole before tax. But not to worry, due to the extra passthrough deductions (I can now annually deduct up to 2.5% of my $100X cost), my taxable income from doing all this is actually minus $3.5X per year. Given my 37% tax rate, I reduce my tax liability by $1.295X per year. So I am a net of .295X per year ahead after-tax, despite losing $1X before tax.

Given all the many opportunities that the tax bill offers for turning pre-tax losses into after-tax gains, in many cases it will be prima facie malpractice by the tax planners if a high-income taxpayer (as determined in actuality) cannot gin up enough tax losses (in excess of any actual economic losses) to escape from that bracket. And for some, the games will keep going beyond this point.

Leaving aside purely sham tax shelter transactions, which anyone with low ethics and a taste for risk can try (albeit, subject to the risk of being caught by a severely under-funded IRS), it will often depend on how conveniently one's particular business activities happen to set one up for finding pre-tax money-losing transactions that happen to have a plausible link to these activities. But of course, creative tax planners will be looking for ways to gin up these links.

There is going to be a lot about this in the press over the next few years, once the deals start happening.

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.

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.