NYU Tax Policy Colloquium, week 8 - paper by Oei and Ring

Yesterday at the colloquium, Diane Ring presented her paper (coauthored with Shu-Yi Oei), Falling Short in the Data Age. This is not a tax paper as such, although it touches on tax topics, but grows out of the authors' interest in the rise of ubiquitous data that governments or firms can increasingly access and analyze, possibly in relation to their work, for example, on "leak-driven law" and on recent workplace shifts that are epitomized by the rise of Uber et al.

The particular angle they explore here is that technological shifts may reduce the "fall-short spaces" that people have long had as a practical matter. Here's an example that I find convenient for purposes of thinking about what they have in mind, although it isn't actually mentioned in the paper. In New York, jaywalking, while illegal, is the norm. This isn't rulelessness - there is a rule, although not everyone always follows it. The rule is that a red light is a yield sign. (I would say check-and-yield, but given how bicyclists operate in NYC you must always check in all directions even if the light is in your favor, and indeed even if you're crossing a one-way street in which no one is coming from the mandated direction.)

This is more than just a fall-short space, in the sense that New Yorkers jaywalk right in front of police who don't enforce the rule. But suppose that - at least in places where jaywalking violates norms as well as laws - there were facial recognition cameras at every corner, so that if you jaywalked you'd get a ticket, levying a fine, by mail (just as can happen when you go through a toll plaza without EZ Pass, & they photograph your license plate).

The issue that would arise then isn't (mainly) that people would be getting fined all the time. Rather, they would stop jaywalking, which would be somewhat good and somewhat bad. (The NYC norm for jaywalking is superior to the blind-obedience norm when properly executed by everyone, but it also invites greater, and potentially costly, errors in applying it.) Plus, we would have the other issues around cameras everywhere telling whomever had access to the footage where one was going all the time.

One could enrich this little example's capacity to stand in for the broader set of problems that the paper discusses by adding in discriminatory enforcement. E.g., suppose Attorney General Barr gets to decide who does and doesn't get a jaywalking ticket.

The paper has laudably broad ambitions, which combine devising a general compendium of issues and categories, with offering a couple of broad takeaways, e.g., (1) space to "fall short" of honoring all of the legal commands one faces is shrinking and this isn't all good, (2) more sophisticated and well-financed players will be especially well-equipped to take advantage of new high-data environments (although that's also likely to be true in other environments). I look forward to seeing the final version.

Most wanted

Someone in our house keeps knocking over garbage cans, looking for small items that are usable as toys.

Based on character and propensity evidence that might not be admissible in a court of law, here is our chief suspect: Gary, aka the Silly Bandit.

I'd say: Butter wouldn't melt in his mouth, except I'm fairly confident that it would.

Talk at University of Toronto Law School on my new international tax paper

Yesterday at the University of Toronto Law School's Tax Law and Policy Workshop, I gave a talk concerning my new paper, "Digital Service Taxes and the Broader Shift From Determining the Source of Income to Taxing Location Specific Rents."

The slides are available here. I'll soon be posting a revised version of the paper on SSRN; the currently posted version is a bit out of date.

It was very nice seeing the folks there. But if you do enough travel, you have to take the rough with the smooth occasionally. Yesterday's fun was having a flight delay of nearly 2 hours when I had only 90 or so minutes of margin built in (due to the previous day's tax policy colloquium at NYU). By running through the airport etc. I managed to get there only 10 to 15 minutes late.

Today was almost even more fun, as the person at the hotel front desk simply forgot to make the wake-up call that they had in their book. Since it was at 4:45 am, the omission could have been rather consequential, had I not also set my phone.

Tax policy colloquium, week 7: Zach Liscow, part 2

My prior blogpost offered some background regarding Zach Liscow’s “Democratic Law and Economics.”  Liscow has been in the forefront among those questioning the merits of following the “double distortion” line of argument to conclude that “legal rules” or other regulatory policy should respond purely to efficiency concerns, leaving distribution to be handled by the “tax system.”

While earlier work by Liscow and others (such as Sanchirico) has challenged the accuracy and completeness of the assumptions that underlie the admonition that distributional issues be ignored outside the “tax” realm, here he accepts the analysis, at least arguendo, but says: What if following it leads to too little redistribution because voters, while not otherwise averse to it, really dislike cash transfers? (This is the demogrant side of the Mirrlees tax model.) While the paper’s formal model defines this as a universal aversion among voters to cash transfers (held even by poor people who would receive the transfers), its textual discussion invokes beliefs about entitlement to pre-tax market income. So we might think of it informally as concerning the higher tax rates that are needed to fund demogrants, rather than about the demogrants themselves.

The paper further posits that this is not generalized anti-redistributive sentiment, but merely reflects “policy mental accounts.” This draws on the behavioral economics insight that how an individual chooses to spend a given dollar may reflect which pot of money or transaction he assigns it to – leading to departures from consistent rational choice, although perhaps understandable as a heuristic or rough rule of thumb to guide choice.

This in turn implies that voters (presumed to influence policy outcomes) who oppose high tax rates to fund large demogrants might be perfectly happy with redistribution accomplished by different means. Perhaps one might think of this as involving the endowment effect on the tax side (i.e., coding precluded market returns differently than those that were first earned then taxed), plus greater tolerance of in-kind than cash benefits on the benefit side.

The paper therefore posits that inefficient redistribution through legal rules might be an overall policy improvement if there is space for it, but not for the first-best of doing it the Kaplow-Shavell way.

Here is a very simple example that I think can be used to help illustrate the paper’s analysis. It’s taken from one of the central cases discussed in the paper, but here I spell it out a bit more.

Suppose the Department of Transportation (DOT) is deciding whether to spend $$ saving a rich person an hour of travel time (via airport upgrades), or a poor person the same hour (via mass transit upgrades). Suppose further that, based on willingness to pay, the rich person values the hour saved at $63, and the poor person at only $25. (The paper derives this from actual data noted in the paper.

OPTION 1, spending the money on mass transit, benefits the poor person by $25 and the rich person by zero.

OPTION 2, spending the money on airports, benefits the poor person by zero and the rich person by $63.

Cost-benefit analysis, as done at the DOT and elsewhere, commonly uses willingness to pay to discern value. So the “efficient” choice is Option 2, spending the money to help rich people because they place greater value on their time. Instead choosing Option 1, e.g., based on valuing people’s time equally and then using benefit to the poor as a tiebreaker, is inconsistent with the view that only the tax system should consider distributional issues.

Let’s now further strengthen the case for Option 2. Using it in lieu of Option 1, but with the addition of a cash transfer from the rich taxpayer to the poor taxpayer, can create a Pareto improvement relative to choosing Option 1.

Again, under Option 1 the parties gain 25 (poor) and 0 (rich).

Under Option 2, they gain 0 (poor) and 63 (rich).

Suppose we adopt Option 2 but the rich person pays the poor person anywhere between $26 and $62 in cash.

Under Option 3a (Option 2 plus a $26 side payment,) they gain 26 (poor) and 37 (rich).

Under Option 3b (Option 2 plus a $62 side payment), they gain $62 (poor) and $1 rich).

Both of these options are Pareto-superior vs. Option 1. So, while this is not exactly the double distortion argument in action, it supports the same conclusion: Do the most efficient thing possible outside the tax system (using willingness to pay as people’s own measure of utility effects on them), and then, with the economic pie having been made as large as possible, use tax-funded cash grants to create a Pareto improvement relative to the case where we used inefficient legal rules to address distributional concerns.

This is a highly stylized and simplified example. But it’s useful to illustrate the line of argument in the Liscow paper. In effect, he accepts the entire thing at least for argument’s sake, but adds a political economy constraint: Suppose that in practice Option 3a or b would happen, in a mass society as opposed to one with just one rich and poor person negotiating, only via higher labor income taxes to fund larger demogrants. And suppose that aversion to high taxes or cash grants means that 3a and b simply won’t happen. So our only choices are Option 1 or Option 2.

Suppose further that, due to other aspects of voter belief systems, they’d be fine with selecting Option 1 – for example, based on the belief that people’s time should count equally and that tiebreakers favoring the poor are okay. But if the regulators believe that only efficiency should drive non-tax decisions, we’ll get Option 2.

In effect, the paper argues that Option 1 might actually be better than Option 2, if we assume both (a) that there is too little redistribution overall due to mental accounting rule disparaging high tax rates and cash grants, and (b) that there will be no marginal redistributive effects to the choice of Option 2 over Option 1. (In effect, nothing will happen towards implementing Option 3 variants.) So the DOT should employ distributional analysis, rather than purely efficiency-driven cost-benefit analysis, in the course of deciding whether it’s better to implement Option 1 or Option 2.

Choosing Option 1 might be here viewed as a standard “leaky bucket” problem in redistribution. The rich lose $63 while the poor gain $25, causing the analysis to depend at least in part on the marginal utility of these values at the applicable income levels. And again, the fact that one might have been able to use a less leaky bucket, if the public didn’t object to the standard optimal tax model, is ruled out of bounds as politically unavailable.

 The if-then logic of the paper is unassailable. It’s a basic second-best thing, aka, the best shouldn’t be the enemy of the better-than-nothing. If there are two paths to addressing distributional concerns, and the better one is unavailable in circumstances where the worse one might be available, then of course one shouldn’t rule out the latter, but should duly consider it.

The harder and more interesting question concerns whether and to what extent it might have significant policy relevance. Here are some quick thoughts about that:

1) Assuming voter control, or positing a fixable asymmetry? The paper posits that voter influence over political outcomes makes it relevant that people have inconsistent views, such that they might dislike redistribution done via taxes and cash benefits, but be fine with it when done by means that a welfarist with an advanced economic understanding of policy instruments might deem clearly inferior. The posited set of viewpoints strikes me as clearly plausible. The assumption that voters actually influence political outcomes sufficiently strikes me as less so. There are well-known studies by the likes of Martin Gilens, Larry Bartels, Benjamin Page, etc., suggesting that the policy views of the 99% have startlingly little influence on actual policy choices in Washington.

However, there is a different reason why the paper’s line of argument might be politically efficacious. Tax policymaking in Washington occurs in a highly politically charged realm in which the players are only marginally subject to influence by what people in the academic and think tank realms are saying. (An example of such influence, however, might be recent academic work by the likes of Diamond, Saez, and Zucman pushing out the Overton window so that 70 percent top bracket income tax rates, along with the use of wealth taxes or similar instruments, are now considered more plausible than they were previously.)

But regulatory policy et al is potentially subject to area-specific influence by specialists and experts, who might even have some discretion despite any political overlords from the Executive Branch or Congress who have the power to rein them in. If they have been thinking that the regulatory process should look solely at efficiency, because that is the climate of intellectual thought under which they have been trained (whether or not they are actually familiar with Atkinson-Stiglitz or Kaplow-Shavell), then it’s not impossible that suasion to the effect that distributional considerations should count here too might affect their judgments.

In other words, one could claim in support of the efficacy of the Liscow paper’s project that it’s addressing an asymmetry, in which the tax realm doesn’t much follow optimal tax theory recommendations re. what it should do, but the regulatory realm does follow the prescription that one should leave all distributional issues to the tax system. Moving towards distribution-conscious cost-benefit analysis might conceivably make a difference here, subject to the “political general equilibrium” question of how this will actually play out in the end overall.

2) General equilibrium political playout: ‘political Coase theorem” versus the baseball game metaphor – As the Liscow paper concedes, the distribution-conscious approach that it urges for regulatory policymaking might not matter after all if what David Weisbach, among others, has dubbed the “political Coase theorem” might apply at the end of the day.

As background, the actual Coase Theorem that’s being invoked here holds that, if transaction costs are zero, it will make no allocative difference – although it might make a distributive difference – whether, say, (a) I have a right to pollute unless you pay me to stop, or (b) you have a right to stop me from polluting unless I pay you to let me do it. Either way, with zero transaction costs it “doesn’t matter” – in terms of allocative outcomes – which way one allocates the initial right. The idea is that the higher-valuing user will end up possessing the right. E.g., if I value polluting at $10 and you disvalue it at $12, then either (a) you’ll pay me between $10 and $12 to forbear if you have the initial entitlement, or (b) I’ll ascertain that I can’t buy the right to pollute from you at the max I’d be willing to pay ($10). So either way, the pollution doesn’t happen. (Of course, the Coase Theorem’s main message actually is that transaction costs are why it might matter who gets the right – not that it generally doesn’t matter.)

Here are two versions of what proponents have called the “political Coase theorem,” adapted to my earlier example with the choice between mass transit and airport expenditure to reduce either a poor or a rich person’s travel time.

Version 1: if the poor person has the power to get mass transit spending that she values at $25 agreed to, in lieu of airport spending that the rich person values at $63, the latter offers the former between $26 and $62 to agree to the latter. So the latter, rather than the former, ends up happening.

As adapted to more real world regulatory choices, Weisbach has noted the possibility that groups potentially subject to inefficient redistribution have an incentive to offer a Pareto deal in which the redistribution is instead done efficiently. This creates surplus that all can share, so one might ask: Why doesn’t this just happen? (In that case, the power to threaten inefficient regulation might matter, but one wouldn’t expect actually to observe it.)

The answer to the question “Why won’t that just happen?” seems pretty clear. As per the Coase Theorem in its standard application, what about transaction costs? Inertia, information costs, disaggregated political power so that different principals cover different policy areas and can’t readily trade with each other, etc., are important enough (I’d argue) that we shouldn’t simply presume that this trade is the ordinary course of things. Sure, it’s a relevant consideration, but if anything the presumption might often lie in the other direction (Why would it be able to happen?)

Version 2: If Congress has specific distributional goals that it pursues coherently and consistently, then in a sense it really won’t care what the regulators do. Or more precisely, even if it doesn’t directly rein them in, it will simply adjust its distributional bottom line so that distribution comes out in aggregate the same as if the regulators had pursued efficiency alone.

I think hardened law and economics types may be prone to finding this line of reasoning more persuasive than it actually is, because they are used to thinking about consistent rational choice by an individual with coherent preferences. But in politics you get all the issues of collective choice, along with pervasive agency costs that include political actors’ frequently greater interest in such things as personal credit-claiming, blame avoidance, and symbolic gesturing, than in substantive outcomes. Thus, even insofar as individuals fulfill the rational actor model of optimization under coherent and consistently followed preferences, collective choice institutions in a modern mass society should not be expected to do this.

Once again, while obviously one has to think about the possibility that Congress will undo (or directly rein in) distributionally minded agencies that are not adhering to pure efficiency (as well as those that ARE adhering to pure efficiency), there is really no reason here for a general presumption that it just won’t matter. That, rather, is the question to be asked.

Here is a model I prefer to the “political Coase theorem” for thinking about why, say, the left or the right might pursue particular distributional (or other) fights as zealously as they sometimes do. Each time you win a battle, you’re that one battle ahead, and it won’t necessarily be offset elsewhere even if outcomes aren’t entirely independent and uncorrelated.

Suppose a baseball team figures to win about half of its games. Bottom of the ninth with two outs, they’re down by one run but have the tying and winning runs in scoring position. So if the batter gets a hit they win, if he makes an out they lose.

Either way, they’re still a .500 team over the long run. But they’re one game ahead if he gets a game-winning hit, relative to the case where he makes the third out. And there’s no particular reason to think that this will be automatically offset. A win today doesn’t, at least inherently, make a loss tomorrow more likely than it would otherwise have been.

Tax policy colloquium week 7: Zach Liscow paper, part 1

Yesterday at the colloquium, Zach Liscow presented his paper “Democratic Law and Economics.” Before getting directly to the paper, I think it’s useful to put it in a broader context that will be familiar to some readers but perhaps not others.

The law and economics movement in law schools, which got going in earnest about 40 years ago, in its early stages made a lot of strides using an approach that some call “Econ 101ism.”  As per Noah Smith:  

“We all know basically what 101ism says. Markets are efficient. Firms are competitive. Partial-equilibrium supply and demand describes most things. Demand curves slope down and supply curves slope up. Only one curve shifts at a time. No curve is particularly inelastic or elastic; all are somewhere in the middle (straight lines with slopes of 1 and -1 on a blackboard). Etc.”

Econ 101ism was a step forward for legal scholarship, but not a step far enough. One had to understand what the logic of a standard neoclassical analysis implied, but the next step required recognizing that its assumptions might not always hold, and then asking what that would imply. It’s a great orienting tool, but its seductive power to purport to answer so many questions, from so parsimonious a starting point, can over-excite the incautious if they forget that they need to take that next step of testing the accuracy and sufficiency of its assumptions.

A more recent trend in what one might call tax or public finance law and economics involves using a very simple model that purports to answer lots of questions. The Atkinson-Stiglitz theorem holds (within the specified terms of its model): “Where the utility function is separable between labor and all commodities, no indirect taxes need be employed.”

Take the Mirrlees model, in which we want to base the tax on ability but can only measure earnings, so we impose a labor income tax that is equivalent to a uniform commodity tax. (Wages are used to buy commodities, and in a one-period model one spends it all currently.) Atkinson-Stiglitz asks whether one might get a better outcome by having non-uniform commodity taxes, e.g., taxing luxuries at a higher rate than the rest. It shows that, within its terms, the answer to this question is NO unless some commodities are leisure substitutes or complements. E.g., if I work more, I may substitute restaurant meals for buying groceries (leisure substitute). Or if I work less I might want to buy a telescope so I can spend hours stargazing (leisure complement). But absent any of that, the uniform commodity tax is best.

Suppose one thought that taxing yachts at a higher rate would have an admitted efficiency cost (discouraging yacht choice vs. other consumption), but also an efficiency gain (raising revenue that permits one to lower the labor income tax rate). So isn’t there a tradeoff, with even an implication that there might be a net efficiency gain, since multiple smaller distortions are often better than just one large one?

Answer: No. You still have to work to get the $$ to buy a yacht, and working is just a way of getting to buy things. So one is still, roughly speaking, discouraging labor supply as much as before, plus one is now also distorting commodity choice. Hence there is now “double distortion” without mitigation of the prior distortion.

Leading figures in tax or public finance law and economics (e.g., Kaplow and Shavell) have shown how broad Atkinson-Stiglitz’s implications might be. For example, one can think of an income tax as imposing higher commodity taxes on future consumption than current consumption, creating double distortion (discouragement of saving) without any mitigation of a consumption tax’s admitted discouragement of work and market consumption. Hence, case closed for the income tax? Yes unless there is more to the analysis, but the point (as with Econ 101ism) is that there might be. (And for what it’s worth, neither Atkinson nor Stiglitz agrees that based on their theorem one should prefer consumption taxation to income taxation.)

Likewise, case closed (within the analysis) with regard to using “legal rules” instead of the “tax system” to redistribute. Here the “tax system” means, not Title 26 of the Internal Revenue Code, but a labor income tax plus demogrant. “Legal rules” means pretty much anything else. E.g., income-conditioned speeding tickets, like they have in Finland. Product liability or tort rules that favor consumers or accident victims on the ground that they’re generally poorer. Mandatory contract clauses to protect tenants. Inducing corporate managers to optimize for “stakeholders,” not just shareholders, under a progressive redistributive rationale.

Under the view, using any of those types of vehicles to address distributional concerns about rich vs. poor merely yields double distortion. You’re still discouraging labor supply, insofar as becoming rich subjects you to expected unfavorable treatment under those rules. Plus, you’re departing from the efficient choice in those areas, which makes things worse overall than if one had just used the labor income tax to address distributional concerns.

The takeaway from this analysis was and is: All analysis of “legal rules” and government policies outside the labor income tax should be driven PURELY by considerations of efficiency. Leave redistribution purely to the “tax system.”

This view has been highly influential in legal scholarship, and also perhaps in regulatory policy as actually done. But it has inspired pushback, both on theoretical grounds (based on whether the underlying assumptions are sufficiently accurate and complete) and in light of concerns that, in practice, it leads to too little progressivity if policymakers adopt it in the realm of “legal rules,” but not when designing the tax system.

This, anyway, is vital background for discussing Liscow’s “Democratic Law and Economics,” to which I will turn directly in my next blogpost. 

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NYU Tax Policy Colloquium, week 6: Katherine Pratt's "The Curious State of Tax Deductions for Fertility Treatment Costs"

As we reached the 42.9 percent point (6 weeks out of 14 now in the books), it was nice to have an abrupt topic shift - one of the things I like best about the colloquium - in this case, from international tax the prior two weeks, to Katherine Pratt's The Curious State of Tax Deductions for Fertility Costs.

Narrowly speaking, this paper responds to a phenomenon we will surely be growing increasingly familiar with in coming years: a pompous, confused, biased, ignorant, and gratingly self-satisfied opinion by a Trump judge, although this individual may have higher than average judicial qualifications among the lot. The opinion at issue is Morrissey v. United States, in which an Eleventh Circuit judge purported to offer a "primer on the science of human reproduction," sharing with lucky readers such insights as: "It is a biological fact that, unlike some lower organisms ... human beings reproduce sexually .... Critically here, within the human reproductive process, the male and female bodies have different roles and purposes."

The judge's motive for so generously sharing these insights with us is that "the circumstances of the case - and the parties' competing contentions" made it seem necessary to him. More specifically, he viewed the plaintiff's contention that an unmarried gay man could claim medical deductions for assisted reproductive technology (ART) expenses (such as for egg donation and fertilized egg surrogacy) as contrary to nature, at least when backed up by (of course) statutory "plain meaning."

Needless to say, the plain meaning is not so clear as our judge-lecturer thinks. Under Code section 213(d)(1), medical expenses include "amounts paid .. for the purpose of affecting any structure or function of the body." I would think it clearly affects a "function of the body" for the taxpayer's sperm to be successfully inseminated in a fertile egg that may may eventually grow into a child who is biologically his. Isn't it a "function" of the male body, in producing sperm, to make possible one's having biological children? That end result is certainly the evolutionarily selected function served by the male production of sperm (if we want to talk Nature).

This is not to say that "plain meaning" resolves the case in the taxpayer's favor. Rather, it shows that other interpretive methods are needed. For example, the fact that the taxpayer would not have needed to incur ART expenses in order to have a biological child, had he been heterosexual and with a fertile female partner - a point of central importance to the judge - clearly is relevant to the analysis. But now we are engaged in a more complex statutory interpretation exercise than he seems to realize is necessary, and one as to which his tediously trying-to-seem-bemused lectures about Nature are unilluminating. The judge's evident belief that section 213 shouldn't be available when people don't seek to produce children in what he thinks is the natural way - and, admittedly, thereby incur costs that could have been avoided had they used his preferred method - involves statutory interpretation via purposive analysis. That's fair enough, methodologically speaking, but it isn't "plain meaning."

Anyway, one reason Pratt wrote the article, in the aftermath of Morrissey, is that the 11th Circuit opinion carelessly (to put the best face on it) misstates actual IRS practice, insofar as one can glean it from limited evidence, with respect to different types of ART-related expenses incurred by differently situated taxpayers. So a bit of clean-up crew was needed in this area, on which she's been writing for a while, in addition to her wanting to address a set of very interesting issues around the tax and other treatment of ART expenses. With that said, let's turn to a few of those issues.

1) Infertility and dysfertility - Even after Morrissey, there are strong grounds supporting the conclusion that section 213 medical deductions are allowable for certain ART expenses, at least in the following scenario. Say that a heterosexual married couple establishes that one of them is infertile, and they therefore pay $$ for fertility treatments of the infertile party. That appears to be deductible. There is also an IRS letter ruling (admittedly, not constituting precedent) allowing various expenses incurred in connection with egg donation to be deducted under section 213 by a woman who was unable to conceive a child using her own eggs.

Morrissey does not contradict allowing ART deductions with respect to the taxpayer's own infertility (or that of "his spouse," as section 213 puts it). But the taxpayer's argument, which the court rejected, would add dysfertility to infertility as grounds for ART deductibility. As per Pratt's paper, dysfertility "refers to individuals who cannot bear children because they are single or in a same sex relationship."

Let's switch from statutory interpretation to policy - since, whether Morrissey is right or wrong as to the former, rejecting it as to the latter would call for legal change. I would argue that there is a compelling case for mandatory government-provided insurance coverage for ART for dysfertility, as well as infertility.

This obviously starts from mid-conversation, so far as government-provided health insurance coverage is concerned. I state it as generally as that to extend the sphere past income tax deductions for medical expenses to the realm of Medicare, Medicaid, single-payer, the mandated scope of universal health insurance coverage, etcetera.

I'd put the starting point for the argument as follows. From behind the veil regarding one's own particular identity within our society, one should recognize that it's very common to have a very strong desire for a biological child, or as close to it as possible, as a joint project with one's partner . One should further recognize that, again from behind the veil, one doesn't know whether one will be one of the people for whom this turns out to be relatively easy - i.e., a fertile heterosexual individual with a fertile heterosexual partner. From this perspective, both infertility and dysfertility are risks - partly converted by modern technology into financial risks, insofar as one can pay a lot of money for workarounds that did not always exist - against which it is rational to want to insure.

But why mandatory government insurance? This requires a market failure that the government can address better than private insurance firms. The most obviously relevant one here is adverse selection - widely recognized now as a key reason for favoring government provision in the healthcare arena, whether it be via the current ramshackle U.S. methods, single payer, or something else. It's very plausible that the government's superior ability to address adverse selection with respect to dysfertility - the risk of which gets affected by knowing one's own sexual orientation and partner preferences - creates a strong enough case to support the intervention.

The other classic issue in government vs. private insurance analyses is moral hazard. Here there is a difference as well. From the perspective of a private insurer, moral hazard is at work if people use ART coverage to do things that they wouldn't have done if forced to bear the full freight financially. But for the government this is not so clear. To a benign government, it's not just financial "waste" if motivated prospective parents get to have children with a particular desired relationship to themselves. (Yes, the fate of children in need of adoption is also part of the larger policy picture, but it's not clear that shutting off other routes to raising a child is part of the optimal response to that.)

2) Beyond dysfertility? - What about ART expenses incurred, say, by heterosexual couples that are neither infertile nor dysfertile? An administrative advantage of not requiring infertility or dysfertility is that one need not demand an inquiry into either when people incurred ART expenses. But this admittedly would come at a fiscal cost that would raise issues of moral hazard, insofar as one thinks these expenses might have been incurred out of a preference for neither going through pregnancy (even when feasible) nor adopting. But I'd be inclined to say the expenses should be covered even without either infertility or dysfertility. Going through pregnancy is a pretty huge thing, with significant potential health costs, impact on one's career and long-term earnings, etc. But I am leaving aside here questions of whether we are uneasy (e.g., for Handmaid's Tale-type reasons) about the extent to which surrogacy becomes a go-to. These are certainly beyond the scope of my expertise.

3) Why run ART expenses through section 213? - As a long literature discusses, income tax deductions for medical expenses are a bizarre way to increase overall government health insurance coverage, relative to what it would be if one simply repealed the provision without changing anything else in the legal and policy landscape. Medical deductions come with an adjusted gross-income related deductible, followed by a marginal tax rate-related co-pay, without its being obvious why this form of government insurance is being interacted with the income tax's general provision of ability insurance / under-diversified human capital insurance.

Even taking the use of section 213 as given, I suppose one might want to treat ART and adoption expenses in the same bucket, although to really do this right one might also want to throw in the marginal healthcare expenses that result from being pregnant, if these could be separately identified. And conceivably one would treat things in this bucket differently than other stuff, just as a well-designed health insurance schemes might vary the deductible, the co-pay, the cap if any on covered outlays, etc., based on the characteristics of particular areas.

4) The paper's proposed solution - Rather than discussing statutory changes that might directly address ART expenses, the paper proposes modifying section 213 in more general terms, so that it focuses on "inherently medical services" and on allowing taxpayers to "restore or approximate typical human functioning." This raises further interesting issues, although I won't explore them here, regarding, for example, the technology-driven rise of "inherently medical" procedures that might allow people to go way above the median (a la the use of human growth hormone by someone of average height who wants to become 6'5").

If only Descartes had met him

Sylvester, who nearly died this summer of a thymoma (along with a nearly disastrous general anesthesia episode that left him blind for 2 days) is now, many weeks post-surgery feeling well enough to meow plaintively, endlessly, and if I dare say so a tad annoyingly for food, to be followed by more food (perhaps more than his stomach will accept in so short a period).

He's so expressive of his often churning inner states that I'm sure Descartes would have realized how wrong he was to think animals are unfeeling automata, if only he had met the little fellow.

This week's Tax Policy Colloquium paper (by me)

This week at the NYU Tax Policy Colloquium, the paper we discussed was mine - i.e., my work-in-progress, entitled Digital Service Taxes and the Broader Shift From Determining the Source of Income to Taxing Location-Specific Rents.

It was a very fruitful session, that has inspired my making a few expansions and clarifications of the analysis in the version that I have posted.

Alas, I'm a bit handcuffed with regard to including a lot of content here. I'm not going to re-post the link to it, although you can readily find it on SSRN, as I'd rather have people read the revised version than the currently posted one. But I'm not quite ready to post that, since (1) I have some readers' comments that I want to look at closely first, and (2) I'll be presenting it at U Toronto Law School's tax policy workshop in a couple of weeks, and might as well take advantage of that feedback as well.

I generally don't discuss the colloquium sessions here, lest they lose their off-the-record status, with potential inhibiting effects on discussion. And discussing it here as if it were someone else's paper doesn't seem quite the thing to do either.

So why don't I settle for posting the abstract, which at present goes something like this:

In recent decades, a number of fantastically successful, mainly American, multinational entities (MNEs) have risen to global economic hyper-prominence. While their market capitalizations and profits are high, reflecting that they earn substantial rents or quasi-rents, their aggregate global taxes are generally quite low, reflecting their ability to create stateless income.

Often, these MNEs are technology companies – but not always. Starbucks, for example, enjoys high global profits and low taxes despite its following a classic brick-and-mortar retail business model. This reflects that, like its more obviously high-tech peers, it relies on valuable intellectual property that helps it in creating both global pretax profitability and stateless income.

Such MNEs’ rise has placed substantial pressure on existing corporate income tax models. While the existing models might perhaps be significantly improved, this would still leave market countries (where the MNEs’ consumers are located) well short of being able to tax, as fully as they might like, the location-specific rents that these companies earn by interacting with their residents.

Market countries that use novel tax instruments, such as properly designed digital services taxes (DSTs) to expand their capacity to reach such location-specific rents, are not acting unreasonably, as judged within existing (and fairly lax) norms for constraining and channeling countries’ self-interested behavior. DSTs also have the potential (although whether it will be realized is uncertain) to improve, rather than worsen, global efficiency and distribution. Whether they prove permanent or merely transitional, DSTs look like harbingers of a new era in which entity-level corporate taxation rightly focuses more on immobile factors and locational rents, and less on decades-old doctrinal and semantic debates concerning the supposedly “true” source of economic income and value creation.

Talk at Reed College last week on my forthcoming literature & inequality book

As noted previously, last week, while in Portland, I gave a talk at Reed College concerning my forthcoming book, currently called Dangerous Grandiosity: Literary Perspectives on High-End Inequality Through the First Gilded Age.

I have now posted a PDF version of my slides for the talk, which you can find here.

The book is expected out in April 2020, with Anthem Press. Its title may change, however, as I gather that common practice counsels having the lead portion of the title (i.e., before the semicolon) give greater notice than it currently does of what the book actually is, and is about.

I am making final textual changes now, after having gotten anonymous reviewer letters. While ( think it's fair to say that the reviewers were highly favorable, they did some editing changes. Worse still (as I like to put it), they made GOOD suggestions, suggesting that I mainly ought to follow them and indeed will.

I'm certainly available for talks regarding the book, especially in 2020.

Tax policy colloquium on transfer pricing regulations

Yesterday at the colloquium, Li Liu of the IMF presented her paper (co-authored with her colleague Ruud de Mooij), At a Cost: The Real Effects of Transfer Pricing Regulations. This paper finds interesting and significant results regarding the play-out when certain EU countries, between 2006 and 2014, adopted tougher and more fully specified rules regarding transfer pricing by multinational companies (MNCs). I found the results credible, both intuitively and in terms of how the paper reached them, although the authors would be the first to agree that, because this is a fairly novel research area, more work is needed to see if similar results arise using different periods and data sets.

I'll offer comments on it here in three buckets: the model it uses, several of its main empirical results, and international tax policy takeaways.

1. THE MODEL

Suppose an MNC is deciding whether to add marginal real investment (e.g., buildings, factories, offices, or stores, whether owned or rented) in a given country where it already has some sort of physical presence. In a standard economic model, this depends on the marginal investment's expected after-tax return (treating, let us say, the MNC as risk-neutral).

If productive inputs would be needed with respect to using the marginal real investment, then one choice the MNC faces is whether to acquire such inputs (a) in-house, or (b) from third parties. Absent tax considerations, this might be a fairly straightforward analysis. But once we have source-based taxation that makes use of transfer pricing under the arm’s length standard, things complexify a bit. Use of a cross-border affiliate permits the MNC to engage in profit-shifting, via the use of a transfer price that is either “too high” (if the source country’s tax rate exceeds that of the affiliate’s country) or “too low” if it’s the other way around.

The more aggressive the transfer price – at least, if it is too high, and one is profit-shifting OUT of, not into, the particular source jurisdiction – the greater the chance that it will be challenged by the local tax authorities. In the model, this triggers two kinds of costs: (a) the chance of a penalty, including via the ultimate selection of a transfer price less favorable than the MNC could have gotten away with had it been less aggressive, and (b) its triggering extra compliance costs, such as from mass document production or paying experts to support one’s position. So there is in principle an optimal level of aggressiveness here.

Suppose that the country initially just had a vague and general “arm’s length” requirement in its substantive law. But then it adopts more detailed substantive transfer pricing regulations (TPR) that specify particular methods, etc.

Focusing for now just on the outbound profit-shifting, the MNC may now find that the optimal level of aggressiveness in its transfer pricing has declined. So it will now expect to face a higher domestic tax liability (including from compliance costs) than before TPR was adopted. It might even switch from using in-house to third party suppliers for some of the productive inputs, but this would only mitigate the expected cost, not make things as wonderful as they were pre-TPR (given that it had previously been using affiliates).

By lowering the expected after-tax return from the marginal investment (or equivalently in the model, increasing the cost of capital), the adoption of TPR would be expected to reduce marginal real investment in the jurisdiction.

As we will see, an important further aspect of the model is that TPR might also constrain inbound profit-shifting from higher-tax jurisdictions. Even though the source country’s tax auditors are unlikely to pose angry challenges to inbound profit-shifting, which increases domestic tax revenues, I presume that the idea here is that, by specifying the applicable rules, TPR restrains what the MNC is able to do in this dimension, consistently with following the new rules. Therefore, and I’ll return to this below as it’s an important point, TPR is assumed to have what I call two-sided, not just one-sided, effects. (It would be one-sided if it only restricted outbound profit-shifting.) The data appear to confirm that this is actually happening.

With two-sided transfer pricing effects, the adoption of TPR need not be a revenue-raiser even if the MNC’s real activity choices are unaffected thereby. But with the adverse effect on the expected after-tax return from the marginal real investment (which might be increased by reduced ability to use it for inbound profit-shifting from higher-tax jurisdictions), one would expect the rate of new real investment in the jurisdiction by the MNC to decline. The paper’s main, but not only, research question is: Does it indeed decline, and if so, then by how much?

Why would the country care if marginal real investment by the MNC declines? While leaving for further discussion below the question of what the country’s full policy aims might be, the paper’s answer is that this might negatively affect positive productivity spillovers that would accrue to the benefit of the country’s residents.

This answer appears to invite (although it does not require) thinking in terms of a conventional two-factor production model (capital plus labor) in which real investment increases local workers’ productivity, and thereby their wages. But often talk of inbound MNC investment focuses on potential knowledge spillovers. More on that distinction shortly.

In terms of thinking about the model’s real-world application, I would add or emphasize the point that often, the relevant MNCs are earning global rents or quasi-rents (from now on, I’ll just say “rents,” for concision) by reason of their valuable intellectual property (IP). Given that the IP already exists, marginal real investment in the jurisdiction is likely only to earn a normal or routine return, at least in terms of its own productive contribution to the process.

Consider, for example, a pharma company producing one of its hot new products at a production facility in a tax haven. The value lies in the patent, and likely not much (if at all) in any of the production facility’s (or its managers’ and workers’) distinctive attributes. Thus, in a true arm’s length negotiation between the pharma company and a third party producer, the latter would likely only be able to capture a normal or routine return.

Ditto for Starbucks operating coffee shops in a given country (which I discuss a bit in my new paper that is nominally or partly about digital service taxes). Whatever large profits the Starbucks global group may be able to rake in by reason of its having, say, a shop every 50 feet (it can almost seem) in London, the value isn’t being added by the local drudges who manage and work in the facility. If Starbucks mainly used franchising in lieu of company-owned stores (and could do this without hurting the brand), you can bet they would extract what they could from the third party franchisees, leaving the latter with only normal or routine returns.

But once we have transfer pricing between affiliated entities, and in the absence of any global consensus that MNC profits should be taxed purely in the true production countries – which is not necessarily where the MNCs have located their IP for tax purposes! – the countries in which these routine production facilities have been placed may have an opportunity to capture some of the rents, under the (probably false) premise that the MNC would have had to share these with the local affiliate, despite its likely quite modest contribution to true value and profitability.

Back to the model and the MNC’s marginal real investment decision: adding such investment in the country might often reasonably be viewed as (a) offering only a modest pretax boost to profitability, since the real assets are likely to earn just a normal return so far as their contribution is concerned, (b) allowing the MNC through aggressive transfer pricing – like Starbucks’ in the UK – to claim zero or even negative taxable income in the country, if it likes, and (c) allowing the country, if it more assertively takes on the transfer pricing challenge, to use it as a vehicle for taxing some of the MNC’s global rents.

With TPR allowing the government to do some of this that is tied to the level of the MNC’s real investment in-country, I think it can usefully be thought of as akin to the case in which local tax profits depend partly on the use of property-based formulary apportionment (FA). Property-based FA operates somewhat like a property tax, except that the local percentage of the MNC’s global property is then applied to global profits that include rents, wherever one thinks they were “actually” created or realized.

Just like TPR as modeled in the paper, property-based FA is two-sided. It can shift profits either into the country or out of it, compared to a method in which true productive contributions were being taxed in the places where they “truly” happened. And TPR as modeled in the paper, just like property-based FA, can mean that inbound real investment carries a property tax-like domestic tax price in the form of having greater domestic tax profits that are not necessarily linked to the marginal real investment’s true (and presumably merely normal or routine) contribution to the MNC’s global profits.

2. MAIN EMPIRICAL RESULTS

The paper is based on studying EU data from the years 2006-2014. During this period, 6 countries introduced transfer pricing regulations (TPR) within the paper’s criteria. All of these countries were fairly small: Bosnia & Herzevogina, Finland, Greece, Luxembourg, Norway, and Slovenia. This raises questions regarding the findings’ more general applicability when larger EU countries – say, the UK (for the moment), France, and Germany – or other countries that are one or both of large and non-EU make similar changes.

That said, the paper’s main empirical results include the following:

a) The average TPR adoption reduced MNCs’ marginal rate of inbound investment by 11 percent.  What is more, the MNCs appear to be investing just as much worldwide as they would have absent TPR’s adoption, suggesting that marginal investments are being shifted to other countries, not reduced. The paper further finds that purely domestic businesses do not appear to be offsetting the reduction in inbound MNC investment by picking up the slack themselves.

Comment: This lives up to the paper’s title – suggesting that TPR comes “at a cost” even if one wants to raise revenue and reduce profit-shifting. But I will return below to the question of how one might think about the relationship between marginal real investment and positive productivity spillovers, given that this may depend on knowledge inflows, as much or more as on the application of a standard capital plus labor production model.

b) TPR’s effects on marginal real investment, as well as on other things such as reported domestic profits, are much greater if the adopting countries also have thin capitalization rules (TCR) than if they don’t.

Comment: This is both plausible and interesting. It suggests that MNCs use transfer pricing and the sorts of intra-group interest flows that TCR can address as substitutes for each other. Hence, countries that want to address profit-shifting need to consider broad-ranging, integrated approaches – as to which, of course, they also need to think about the full range of likely effects.

c) TPR appears significantly to reduce reported domestic tax profits, and thereby tax revenues (under constant statutory corporate income tax rates) in low-tax countries. In high-tax countries, there was a smaller finding of reduced profits and tax revenues, but it lacked statistical significance.

Comment: An issue about the paper’s distinction between high-tax and low-tax countries concerns the small group of 6 (themselves small) EU countries that adopted TPR during the period under study. This implies just 3 countries in each group (although a given country’s status as high-tax or low-tax may have differed as between years), and one wonders also about the classification metric. Luxembourg, for example, has a reputation for being lower-tax in practice, and deliberately so, than one might have thought from merely consulting its statutory rate. And even if the other 5 countries weren’t trying as hard to be accommodating to MNCs, issues of their (possibly either low or heterogeneous) capacity to audit effectively might affect what status they really ought to have in this regard.

Explaining this result – especially given finding (d), which I’ll discuss next – appears to require placing some weight on the two-sided character of TPR changes. Low-tax countries would have in particular the prospect of revenue loss from reduced inbound profit-shifting. And that’s one of only two mechanisms to explain the finding – the other, of course, being reduced inbound investment by reason of TPR’s adoption.

If we fully accept this result, it’s potentially pretty decisive in its impact on the question of whether, from a unilateral national welfare standpoint, a country like the 6 in the study ought to push ahead and adopt TPR. Losing revenue while ALSO marginally discouraging inbound real investment does not sound like a great step forward.

d) Adopting TPR causes what the paper calls the “TPR-adjusted corporate income tax rate” to be 23% higher. This is not a finding about post-TPR effective tax rates. Rather, it concerns MNCs’ sensitivity to the statutory rate. Apparently, for such purposes it’s as if this rate has increased by 23% of its pre-TPR level, presumably given that outbound profit-shifting (if desired) is now harder to accomplish than it had been previously.

Thinking about this finding in conjunction with finding (c) suggests to me that TPR may significantly increase expected compliance costs. After all, why act as if the rate were now 23% higher if one isn’t actually going to be reporting more profits and paying higher taxes? The relationship I suggest here may not be entirely certain, but would make it easier to explain why an MNC might be reporting lower profits, paying lower taxes, and yet being more averse than previously to the unchanged statutory rate.

3. MAIN POLICY TAKEAWAYS

Two in particular occur to me:

a) The “at a cost” framing and empirical takeaway (from reduced inbound real investment) fits well into my general normative framework these days for thinking about international tax policy – which is that countries face a host of what I call “Goldilocks issues.” The little girl in the Three Bears fairytale liked her porridge best if it was “just right,” rather than too hot or too cold. Likewise, countries that are setting their policy at a number of different margins – e.g., how to tax inbound investment from MNCs that may be more tax-elastic than purely domestic businesses, how to tax outbound investment by resident MNCs, and how much outbound profit shifting by MNCs to tolerate – often don’t have a clear right answer at a given 1-or-zero pole. Rather, tradeoffs place them somewhere in the middle, although unfortunately “just right” is likely to be harder to find than it was in the fairytale for Goldilocks herself.

Revenue-raising TPR that reduces inbound real investment would very plausibly raise exactly these sorts of tradeoffs and intermediate solutions. So I welcome empirical research that may help us in evaluating tradeoffs, and indeed in understanding what they are.

b) Adopting TPR looks like it was a bad idea in the particular circumstances that the paper examines. But that might crucially depend on its two-sided character, rather than on the inherent challenges (real though they are) of responding to tax competition unilaterally.

What might be a plausible unilateral national welfare objective for a country, like the 6 that adopted TPR in the survey data? It might be: revenue-maximization from MNC taxation, adjusted for any negative effect on positive productivity spillovers.

Two considerations make the revenue maximization piece especially plausible here. First, at least for the likes of those 6 countries, the MNCs are likely to be almost 100 percent owned by foreign shareholders. Thus, taxes on the MNCs that those shareholders bear economically are likely to transfer wealth from foreign individuals to the domestic Treasury. Second, the extent to which the MNCs are earning global rents raises one’s confidence that their shareholders will bear the MNC taxes economically – a prospect that might be dim indeed if the MNC was merely earning normal returns that it could also earn elsewhere. So the presence of rents, and the country’s capacity to reach them, not just the marginal local returns to real investment, is crucial to this conclusion.

Once one is actually losing revenue from TPR, things don’t look so great from it. But this is easy to understand in the framework where we think of TPR as akin to increasing property-based FA. So the lesson for me is to find other ways of getting at rents. As my DST-et-al paper discusses (and thus, as will be a center stage issue at next week’s NYU Tax Policy Colloquium), this inquiry might lead one in very different directions. It requires that one think further about such options as (1) sales-based FA and its more sophisticated sibling, residual profit allocation, and (2) novel tax instruments such as digital service taxes or diverted profits taxes.