Wednesday, May 04, 2016

NYU Tax Policy Colloquium, week 14: Monica Prasad's "The Popular Origins of Neoliberalism in the Reagan Tax Cut of 1981"

Yesterday, in our final session for the semester, Monica Prasad presented the above paper.  While published in 2012, it's a current project in that she is planning to expand it into a book.

The paper studies the enactment of the Reagan ERTA tax cut of 1981, taking advantage of recently released Reagan Library materials that cover not just the early Reagan Administration but the proposal's formation during the period of the 1980 presidential campaign.  A central thesis of the paper is that this story, when properly understood, clashes to a degree with a common narrative regarding the rise of neoliberal policies more generally.

Suppose we define neoliberalism as a set of policies that took hold in the U.S. under Reagan (although in certain ways extended by Clinton), and in the U.K. under Thatcher, that involved pro-market retrenchment, relative to New Deal through 1960s-style policies, through such measures as privatization and deregulation of business activity, free trade, fiscal austerity, lower tax rates, and changing welfare benefits to place greater emphasis on work incentives.

In the 1990s (heyday of the "Washington Consensus"), such measures were lauded as the golden key to prosperity and growth.  In the post-2008 era, they have faced criticism as sources of rising high-end inequality and economic instability.

While the question of how much truth one ultimately assigns to each of these two views is independent from that of how neoliberal policies actually gained sway politically, the more negative view perhaps encourages looking for big business's fingerprints.  But for the 1981 individual tax cuts that were ERTA's centerpiece, the paper finds that business (the Chamber of Commerce et al) was not supportive.  Indeed, business leaders were skeptical about the individual tax cuts, due to concern both about their budgetary and macroeconomic effects, and about whether their large size would lead to a scale-back of the business tax cuts in ERTA that these leaders of course loved.  (This latter concern was prescient - the offsetting tax increases that the Reagan Administration successfully backed in 1982 and 1984 did indeed come from the business side of the ledger.)

One shouldn't necessarily expect all neoliberal policies to have the same genesis.  In addition, the political forces that produce them need not be the same as those that later sustain them, once they have contributed to the economic and social transformations of the last 35 years.  But the 1981 ERTA tax cuts are well worth looking at for the own sake.  In retrospect - and largely due to subsequent events - they have become the dominant tax policy act of the last fifty years.

The other candidate for this title is the Tax Reform Act of 1986.  But looking at modern tax politics, I would say that the dominant meme - although perhaps its day is finally close to passing - is that of the 1981 Act, as modified to incorporate the 1986 Act.  But this involves its having an accepted meaning that it didn't initially have, by reason in particular of the presidential elections in 1984 (Mondale advocates tax increase, loses in a landslide) and 1992 (Bush I backs off his "read my lips, no new taxes" pledge, and loses, supposedly for this reason, although actually 95% for other reasons).

So where are we now with the 1981 Act?  Initial point: at a minimum, it was not insane.  For example, marginal rates were quite high then (and if they should be  that high again, it's for different reasons - the rise of high-end inequality since that time).  And when revenue losses exceeded expectations - not just due to the local inapplicability of the Laffer Curve, but to the unexpectedly rapid decline in inflation - the Reagan Administration, being run by sane adults quite unlike any known Republicans in the leadership ranks since 1994, promptly got behind tax increases in 1982, 1983 (for Social Security), and 1984.

But once it was ratified as Saint Reagan on the Holy Mount, and once the actual Reagan Administration (with its support for multiple offsetting tax increases) was forgotten, it became this thing - this meme - that grotesquely distorts modern tax policy and needs to be buried forthwith with a stake through its heart.  We have a long-term fiscal gap and rising high-end inequality - so let's not continually try to repeat this Ur-moment with zero regard for the actual surrounding circumstances.

Its perverse and brain-dead grip on policymaking, especially on the Republican side (but with the Democrats generally having little to say against it) brings to mind a reverse Jimmy Stewart from Vertigo.  He has this searing memory that he can't put behind him, so he wants to relive it.  For policymakers, Saint Reagan on the Mount (1981 with a tincture of 1986) is apparently so thrilling a memory - as misremembered - that they, too, are doomed to just keep on trying to relive it.  The ultimate consequences may be as dire for the United States as they were for the Jimmy Stewart character in Vertigo - if, for example, Trump's gynormous (synonym for "yuuge") proposed tax cuts end up being enacted.

I call the dominant meme 1981, with just a tincture of 1986, because the main feature is reducing the rates, especially at the high end, and losing lots of revenue.  But the tincture of 1986 manifests via claims or gestures towards offsetting base-broadening.  In 2012, for example, Romney falsely claimed that he could make his tax cuts revenue-neutral and distribution-neutral through unspecified magic-asterisk offsets. And it's generally common practice these days for Republican presidential candidates to include some base-broadening, even if they fall far short of claiming revenue neutrality so that they can avoid being accused (as Romney was) of planning to raise taxes for the bottom 99%.

But here's one hopeful development from the 2016 presidential campaign (if that doesn't sound too oxymoronic).  It's true that all 17 Republican candidates proposed gigantic tax cuts.  And it's also true that the apparent winner was the one who proposed the largest tax cuts of all.  But no one cared - least of all Trump himself.  He pretty much never discussed his tax cuts on the stump.  They weren't a sales pitch in his campaign.  And the other candidates found that their tax cuts weren't an effective sales pitch, even just with the Republican primary electorate.

So maybe 1981's death grip will loosen at some point, although this depends on (a) the outcome of the election and (b) where the Republicans go next if Trump loses.

But whether or not the 1981 death grip loosens any time soon, there's been an interesting transformation as between 1981 and today.  As Prasad's article shows, among influential Republican insiders in 1981, support for the tax cuts was decidedly muted and mixed.  Jack Kemp had come forward as a policy entrepreneur, and state-level tax revolt events, such as Proposition 13, had caught Reagan (among other leading Republicans) flat-footed, yet intrigued by the political possibilities.

Reagan proposed the tax cuts that turned into ERTA partly just to keep Kemp on the sidelines, and to get his support. Then Reagan and his team stuck to it partly because political leaders pay a price if they are viewed as "flip-flopping." The other main reasons for the proposal, according to the sources Prasad finds, were (a) the public seemed to like tax cuts, so maybe it was a good way to try to win the election, and (b) frustration over 1970s stagflation created a widespread appetite for doing something, anything, differently somehow.

So the 1981 tax cuts had a measure of popular support, leading to their cautious and ginger embrace by insiders and elites.  But today it's the other way around - tax cuts are an elite / Washington insider cause, enforced on Republicans by Grover Norquist et al, and reflecting as well our political turn towards plutocracy.  It's not coming from the voters, although this is not to deny that they could potentially be sold a package of tiny tax cuts for them plus gigantic tax cuts for billionaires.  (This is the Bush 2000 model that all Republican candidates still follow, or at least pretend to follow.)

It's also not to deny that tax increases remain a hard sell.  Both President Obama and Hillary Clinton, for example, have consistently opposed them, other than for people at high income levels.  This presumably reflects their political read - and while it may be a timorous one, that's easy for me to say as I am not running for office.  (Sanders would be a test case, but I suspect the test wouldn't go well for him in the general election, or at least in a normal general election.  However, this may partly reflect his particular limitations and vulnerabilities.)

A final point about the 1981 tax cut that the article makes clear is that, politically inevitable though it may appear with hindsight today - given its having spawned multiple decades of slavish yet distorted imitation - in many ways it was the product of a set of accidents.  Even apart from the fortuity of Reagan's proposing what he did, suppose that either (a) Carter had sent one or two more helicopters into the Iranian desert, (b) Carter had prepared a snappy comeback for Reagan's famous debate line, "There you go again," or (c) Reagan hadn't been shot in March 1981.  It's conceivable that, whether for better or worse, in any of these scenarios modern tax history might look significantly different than it actually does.

The Sheppard-Lennon debate

In Lee Sheppard's Tax Notes column this week, before segueing to her actual (tax) topic, she offered a well-deserved Prince tribute, but couldn't resist a drive-by slag at the Beatles, in the form of claiming that George Martin was their most important member.

I'll subcontract the answer to this to John Lennon, from a 1971 letter:

"When people ask me questions about 'What did George Martin really do for you?' I have only one answer, 'What does he do now?'  I noticed you had no answer for that!.... [A]nd, by the way, I hope Seatrain is a good substitute for the Beatles."

Had he written this letter 3 years later, he could have added America and "Tin Man" - a song that is unforgettable if you listened to the radio in the early 1970s, but not for lack of trying.

(Sorry, George Martin, whom I of course appreciate and admire.)

Thursday, April 28, 2016

Deferred cat exchange with a famous neighbor

I won't give the name, because that would be creepy, but there's a famous person living on our block - famous enough to have drawn, not just tourists,but also paparazzi.  Let's just call this famous person FP.

I see FP occasionally on the street, but have never said anything because it would be invasive and probably unwanted.  One thing about New Yorkers - we generally let famous people be.  But once, close to 10 years ago, our cat Buddy, who was an extraordinarily gifted escape artist in his youth, got out our backdoor, went over the fence, and disappeared for almost a week.

I finally saw him, from several backyards over, sitting on FP's balcony.  He started to meow at me, perhaps ready for his excellent adventure to end.

One of the mysteries was how he had gotten to this balcony.  It was on the second floor, and there was no obvious access, even for a cat (e.g., no steps or overhanging tree).

FP was away (it was NYC summer, after all).  But with help from a neighbor we were able to reach FP's "people" and get Buddy back.  He looked just fine, by the way - neither scrawny nor ragged nor bloody, despite all the hazards that a cat may face in the urban outdoors.  But Buddy is calm and resourceful - I would even say rational - as well as willing to enlist human help (especially that of humans with food).

OK, let's go forward a few years.  This morning, I found this individual, pressed right up against our front door.  (Brown tabby like Buddy, but long-haired and female.)  The picture may not do her full justice.  She was cowering a bit, but she didn't act especially afraid of me (and liked being petted).  When we opened the door, she went right in.  We gave her food, water, and a litter box, while isolating her from our already numerous cats.

She had a collar with name tag and phone number. The address that came up on a Google search of the number is 0.7 miles away.  So we were wondering how she got to our place.  But no less than Buddy after his adventure, she was sleek, clean, and seemed fine.

When we got through to the phone number that was listed on her collar, it eventually turned out to be one of FP's people,   That solved one mystery: she had apparently just gone down the street from FP's house, rather than covering 7/10 of a mile across lower Manhattan.  Said person promptly came and reclaimed the cat on FP's behalf, so the story has a happy ending for everyone.  (Not that we mightn't have considered keeping her if unable to find where she came from.)

If I were teaching Tax I (Individual Income Taxation) this semester, I suppose I would ask the students: Might this (at least, with a few harmless tweaks to the actual facts) count as a deferred like-kind exchange under Internal Revenue Code section 1031?  Let's see:

Exchange? Obviously no - we each just got our own cats back.  But here's where we can change the facts, so as to make the rest of the analysis potentially relevant. Suppose that it had been an actual and intended trade, in which FP gave us Buddy some years ago, in exchange for our furnishing this individual to FP earlier today.  After all, they say possession is 9/10 of the law, and each of us had physical custody of the other's cat, however briefly.  So let's just overlook this point, even though it's negatively dispositive, and do the rest of the analysis.

Like kind?  Yes.  They're even both tabbies, albeit long-hair versus short-hair.  But I think this requirement would still be met, as between two house pets, even if one of them were an octopus (which apparently make interesting companions, at least if you can care for them properly). See Code section 1033, which provides that "involuntary conversions" of property are tax-free if the "before" and "after" properties are "similar or related in service or use."  This is generally viewed as a narrower standard than like-kind under section 1031, so the fact that both are pets should do it under section 1031 as well.  (And let's suppose that we actually held the girl as a pet, as we would have been willing to do.)

While section 1031(e) states that "livestock of different sexes are not property of a like kind,"  I'd give a "will" opinion to the effect that cats are not livestock.  Dictionary.com defines livestock as, among other things, "useful animals," and cats - despite their mousing abilities, which they generally will deploy free of charge - appear to glory in not being "useful."

Property? Well, it's said that you can never really own a cat (it's more like the reverse).  But sometimes they let us pretend otherwise.

Held for productive use in a trade or business?  If you ever try to make "productive use" of a cat, good luck with that, and you have my sympathies.  As an aside, Key and Peele just completed a movie in which they co-star with a kitten, and apparently - even with multiple actors to play the one role - they found it almost as challenging as the Coen brothers did, when they made Inside Llewyn Davis.  (There's a story about this somewhere on the Internet - one of the Coens says they swore, never again.)

Held for investment?  As it happens, no, although at least here (for a fertile member of a show-worthy breed) we'd be in the realm of feasibility.

Within the 45-day identification period and the 180-day transfer period for deferred exchanges?  No, not even close.

Not looking good for the like-kind exchange, so it's certainly a relief that there was no taxable event here to begin with.  This spares us the valuation problem (cats are cheap, leading to low basis, but their owners may highly value them).

Wednesday, April 27, 2016

NYU Tax Policy Colloquium, week 13: Jane Gravelle's "Policy Options to Address Corporate Profit-Shifting: Carrots or Sticks?"

Yesterday Jane Gravelle presented the above paper, which she actually wrote for our session.  It addresses possible responses to profit-shifting by U.S. multinationals, either via carrots or sticks.  The carrots, or incentives to reduce profit-shifting, that it discusses are (1) lowering statutory tax rates, (2) patent or innovation box proposals, and (3) a lower tax rate on royalties earned abroad.  The sticks, or compulsory measures to reduce profit-shifting, that it discusses include (1) ending deferral and possibly cross-crediting, (2) restricting deferral and cross-crediting through interest allocation and foreign tax credit pooling, (3) expanding the scope of subpart F, (4) anti-inversion rules, and (5) formulary apportionment.

A starting point for the paper's analysis is a brief review of the empirical literature of the magnitude and U.S. tax rate elasticity of profit-shifting.  It concludes that the elasticity is fairly low.  Thus, for each dollar of tax revenues lost by lowering the U.S. corporate tax rate, only between one and nine cents would be recouped via reduced profit-shifting.

In principle, one might expect profit-shifting to be highly elastic.  After all, it's defined as finding ways to change the jurisdiction in which income is reported without actually changing anything significantly on the ground.  Nonetheless, a low elasticity measure makes intuitive sense given that profit-shifting typically permits the underlying income to be placed in a tax haven and taxed at zero percent.  Also, while  we don't have really have great models regarding how to think about profit-shifting, it's plausible that it requires incurring certain fixed costs, but then has low marginal costs for a while until somehow it reaches its limit.  (Not all of multinationals' profits end up in tax havens, after all.)  Is there a "cliff" at the end?  Or a range of rising marginal costs that suddenly grow steep?  (These could involve, e.g., audit risk and/or inconvenience from tying up internal funds.)  It's not entirely clear. However, low elasticity makes intuitive sense if, to some extent, companies are asking themselves - once the fixed costs have been incurred, and if there's a "cliff" that they've already reached - whether they'd rather pay tax at zero or at the U.S. rate.  From that standpoint, 25% might not be that much different than 35%, implying low elasticity.

This empirical point governs the paper's analysis of using carrots to reduce profit-shifting.  It suggests that one should not enact tax cuts for multinationals just so they'll do less profit-shifting, because there's still likely to be a large revenue loss.

The paper takes the view that the main problem associated with profit-shifting is revenue.  Once that's the framework, then of course one shouldn't lower tax rates in response to profit-shifting, unless we're above the peak of the Laffer curve, which the low elasticity estimates contradict.

I agree that there's a fallacy or non sequitur in arguments for lowering the corporate rate, etc., in response to profit-shifting.  But, if one is thinking about what international tax policy ought to look like, rather than about bad arguments that are  currently being made in Washington, the issue raised by profit-shifting isn't revenue - it's revenue in relation to deadweight loss (plus of course distribution issues, although these require thinking about corporate tax incidence).

Profit-shifting surely does waste some resources (both directly in terms of its enabling mechanisms, and indirectly via the operation of deferral), but the core point about it is that it enables multinationals to reduce their effective tax rates.  So the big question is what  their effective tax rates should be, and and also how one gets there (e.g., what role, if any, should deferral and foreign tax credits play).

There are tax neutrality reasons for wanting multinationals (both U.S. and foreign) to pay the same effective tax rate on their U.S. economic activity as purely domestic businesses.  On the other hand, there are tax elasticity arguments for allowing multinationals to pay a lower effective tax rate, since they have more of an option to leave.  I regard these issues as fundamentally intertwined with the question of how best to respond to profit-shifting (which might be seen as having, in recent years, overly lowered multinationals' effective tax rates, even if one would be fine with their doing so up to a lesser point).

Plus, as I've written about elsewhere, there are major problems with how the U.S. rules get to the effective tax rates that they end up imposing.  Not to expatiate at length on all that here, but I regard both deferral and foreign tax credits as terrible rules (compared to simply having a lower statutory tax rate for foreign source income) that happen to have the odd effect of somewhat offsetting each other.  Less "lockout" if you can claim foreign tax credits; less dampening of the incentive to avoid foreign tax liabilities if you will be claiming deferral indefinitely.

So there's clearly a broader conversation needed, beyond just revenue.  But the low elasticity estimates do indeed suggest that "carrots" shouldn't be adopted on revenue grounds in response to profit-shifting.

Measurement error?

I felt reasonably strong on the elliptical machine today (trying to work off yesterday's colloquium meals), but I hadn't thought my heartbeat was quite that low.

Friday, April 22, 2016

More on the implications for Social Security policy of workforce heterogeneity

In a recent blog post, I mentioned that Anne Alstott's new book had got me thinking about how the Social Security system ought to make greater use than it currently does of information that it collects regarding people's career earnings.  Specifically, low-earners are more likely than high-earners to suffer a significant "ability drop" as they enter their sixties - strengthening the case for empowering the former, relative to the latter, to choose an affordable earlier retirement without penalty.  Also, when prospective retirees are choosing between early and late retirement options, with annual benefits being adjusted accordingly, the fact that low-earners generally have lower remaining life expectancies than high-earners, at any given age, means that their "neutrality points" with regard to this choice may systematically differ.

Neil Irwin, in his Upshot column in today's New York Times, makes another point that is related to this theme.  As recent research by Raj Chetty et al has shown, the fact that high-earners have longer life expectancies than low-earners means that the former may often get higher internal rates of return from the system than the latter, even though the benefits formula has a progressive declining-match-rate feature.

This suggests that, in principle, if an insurer in a robust private market was offering life annuities to people who were near retirement age, and if it had ready access to information about career earnings, it would have reason to use this information in setting the relationship between premiums and annual benefits.  Otherwise, it would face adverse selection (i.e., high-earners would be able to masquerade as having average, rather than above-average, life expectancies).

The more I think about it (although I am not currently planning to write about it - too much else on my plate), the more it seems like career earnings-based heterogeneity in the workforce is an interesting frontier to think about in Social Security design, and not just on the standard redistributive ground that lifetime income may be relevant to need.

New Jotwell "jot"

I'm not sure when it will be out - June or earlier - but I have penned (or rather keyboarded) my latest annual mini-essay for Jotwell, or the "Journal of Things We Like (Lots)."

My prior three "jots" concerned a Benn Steil book on Bretton Woods, Piketty's Capital in the 21st Century, and work by Michael Knoll, Ruth Mason, Ryan Lirette, and Alan Viard concerning the legal concept of discrimination against interstate commerce.

This time around, I'll be discussing Branko Milanovic's new book, Global Inequality: A New Approach for the Age of Globalization.

Thursday, April 21, 2016

For those in the NYC area

My wife, Patricia Ludwig, will be showing some of her quilts at an artists' / artisans' spring sale in lower Manhattan, two weeks from today.

I was reminded of her quilts by my current process in working on a chapter, regarding Charles Dickens's A Christmas Carol, for my projected literature book.  At the moment, the chapter's components are, in effect, lying around in scraps, much like the pieces of her quilts before she assembles them.  I can only hope it comes together in the end even half as well.

Wednesday, April 20, 2016

New book by Anne Alstott on Social Security

Anne Alstott spoke at NYU Law School today regarding her new book, Social Security, A New Deal for Old Age: Toward a Progressive Retirement.

I haven't read it yet, but plan to.  It contains a detailed plan for modifying Social Security that, for many people, will be its chief takeaway - including, for example, a proposed floor on benefits and gradual removal of the "free" secondary earner benefit, grounded in discussion of economic and demographic changes over the last few decades.  These are certainly changes that I would view sympathetically.

But I'm a bit of a quirky reader - I tend to be more interested in useful conceptual tools that help me to advance my understanding than I am in reform specifics.  From that standpoint, here was my favorite takeaway from the talk.  The book proposes using information that the Social Security system has regarding one's career earnings (or at least covered earnings) through age 62 to affect the relationship between annual benefits under early, normal, and late retirement.  Or more specifically, rather than just having the three options of early, normal, and late like current Social Security, it proposes a gradient of annual benefits, for any given career earnings level, depending on which retirement year one chooses as between ages 62 and 76.  But onto the conceptual part.

Here are two things that are generally known among people who discuss Social Security policy.  First, while high-earners often have the types of jobs in which they can easily keep going long past age 65 or 70, this is not so true for low-earners, who often really are physically constrained in a new way, relative to their jobs' requirements, by the time they reach the early 60s.  Second, life expectancy is now significantly greater for high-earners than low-earners.

Both points show (as has been previously discussed by various analysts) that it is not so obvious that we should generally raise the Social Security retirement age, even if average life expectancy is increasing.  But why stop the analysis there.

The first point also shows that low-earners with inadequate retirement savings may need to choose early Social Security retirement even if it is actuarially bad for them.  The second point shows that, if one wants the tradeoff between early, normal, and late retirement to be actuarially neutral as to a given individual, one needs to distinguish between low-earners and high-earners.  They will have different neutrality points, so far as the tradeoff between annual benefit levels and the expected lifetime value of the retirement benefits is concerned.

Alstott proposes to have the decline in annual benefits, as one chooses between retirement at age 62 or 76 or somewhere in between, depend on career earnings.  Low-earners get a more favorable tradeoff, so that it's easier for them to retire early in both an absolute and relative sense.

Conceptually, I think of this as using Social Security's information about career earnings in a new way.  The fact that a given individual had low, rather than high, career earnings is evidence, statistically speaking, of both (a) a drop in current-period earnings "ability" when one reaches the early 60s, and (b) a low individual life expectancy, which is relevant to the actuarial neutrality point from retiring early versus late.  This is information that the system can use creatively in benefit design.

With rising income inequality producing (and/or being produced by) rising heterogeneity as between members of the workforce at the high end as compared to the low end, it's increasingly important to use such differentiating information.

"The Mapmaker's Dilemma in Evaluating High-End Inequality"

I have just submitted the above-titled paper to SSRN, and I believe it can be accessed here.

The abstract is as follows:

"The last thirty years have witnessed rising income and wealth concentration among the top 0.1 percent of the population, leading to intense political debate regarding how, if at all, policymakers should respond.  Often, this debate emphasizes the tools of public economics, and in particular optimal income taxation.  However, while these tools can help us in evaluating the issues raised by high-end inequality, their extreme reductionism – which, in other settings, often offers significant analytic payoffs – here proves to have serious drawbacks.  This paper addresses what we do and don’t learn from the optimal income tax literature regarding high-end inequality, and what other inputs might be needed to help one evaluate the relevant issues."

It will be appearing in volume 71 of the University of Miami Law Review.  Although a distinct and freestanding piece, it relates to my book in progress on high-end inequality and literature.  No discussion of literature within it, however - rather, it gives my view of why such approaches as mine in the literature book might be needed to supplement what we can learn from standard practice in the public economics and the optimal income tax literatures, with respect to evaluating the social consequences of rising high-end inequality.

NYU Tax Policy Colloquium, week 12: James Alm's and Jay Soled's "Whither the Tax Gap?"

Yesterday at the colloquium, James Alm and Jay Soled presented their paper, “Whither the Tax Gap?”

The paper argues that, contrary to widespread anxiety about the tax gap, there are actually several reasons for thinking it may shrink.  In particular:

1) The use of cash, which is much harder to trace than banking, card, and phone app payment transactions, is in decline.  Even if the use of cash doesn’t disappear, the convenience advantages of using other payment methods may reduce the net expected benefit from using it to facilitate evasion.

2) Computerization generally makes it easier for tax authorities to access data and process it readily.

3) The relative shift of employment from small to large businesses means that there will be more reporting and less opportunity for under-the-radar screen evasion.

To each of these observations, there are possibly counter-arguments.  For example, as to (1) and (2), perhaps it’s hard to predict which way technology will go, as between the “cops” and the “robbers.”  Bitcoin is an example of a non-cash technology that might end up having the same advantages as cash for would-be evaders.  As to (3), perhaps in some ways different types of problems may pertain to large businesses.

For example, suppose we define the tax gap as the difference between what was paid in taxes and what should have been paid.  Say that a large business does ten things on its tax return, each purporting to save $1 million of tax, and classified as tax avoidance rather than tax evasion, except that the legal permissibility of each is open to question.  Suppose, for example, that each of these items has an independent 40 percent chance of being upheld if the IRS understands and fully reviews.  (Suppose further for simplicity, albeit perhaps na├»vely, that this 40 percent probability is truly a frequentist one, rather than just expressing someone’s subjective probability.)

Then, on average, the “true” tax gap as to this company is an expected $6 million.  To be sure, under standard measuring techniques, none of this would be included in the tax gap (nor, perhaps, could it be).  But it would fit within the broad conceptual definition that I gave above.  And it might be viewed as indicating that the nature of enforcement problems had merely changed, rather than necessarily easing.

Still, there's something to be said both for a thought-provoking against-the-grain prediction, and (if the prediction proves correct) for lessening outright fraud as an enforcement problem.

Tax policy "debate" at yesterday"s NYU-KPMG Tax Policy Lecture

Yesterday at NYU Law School, I participated in a “debate” with audience voting on alternative propositions at the annual NYU-KPMG Tax Lecture.  Other panelists were Bob Stack from Treasury, Michael Plowgian, David Rosenbloom, and Paul Oosterhuis, plus Willard Taylor was the moderator.  The debate propositions were preceded by a talk by Oosterhuis and Rosenbloom on the Treasury’s newly issued proposed regulations under section 385, which provide that, in certain cases when one member of an affiliated group distributes what’s ostensibly a debt instrument to another member of the group, the instrument is classified as equity, rather than as debt.  The point is to disallow interest deductions by U.S. companies (owned by foreign companies) that might otherwise serve to strip profits out of the U.S. tax base – not limited to companies that have recently inverted.

One point that emerged from the talk was that, in principle, it might have been better for the Treasury simply to deny interest deductions in these cases, rather than reclassifying the instruments as equity (which potentially has broader implications, not necessarily within the purpose being served).  But the fact that the Treasury was acting under section 385, which deals with debt versus equity classification rather than with the allowance of interest deductions, presumably made this necessary.

Anywhere, here are the debate propositions, followed by approximations of what I tried to say.

1) Regulations proposed 2 weeks ago under section 385 would treat the distribution of a note to a related foreign person (and similar transactions) as equity, disallowing any deduction for interest.  Is this a good idea?

Since the moment the new regulations came out, I have been expecting the net balance of public commentary to be heavily slanted against them.  And while I found the Oosterhuis and Rosenbloom comments at the session to be thoughtful and fair, I am still expecting this.

Both Steve Shay of Harvard Law School and Steve Rosenthal of the Urban-Brookings Tax Policy Center have been speaking publicly in favor of the regulations.  (Shay helped point the Treasury in this direction.)  But most of the other people who will be commenting have client interests, and/or are comfortable with the way things were before the regs were issued.

One possibly countervailing factor, however, is that those who are speaking for or on behalf of U.S. firms that aren’t inverting may be glad to see foreign firms’ relative advantage in profit-shifting out of the U.S. narrowed by the new rule – although only “new” earnings-stripping by such firms, as distinct from that which they already had in place, is potentially impeded.

Academic types, such as myself, even when willing or strongly inclined to take a pro-government position, don’t generally go as deep in the weeds as one would need to go in order to address the rules in detail.  (And while we can certainly do legal analysis of them, we may not be as well-equipped as people in practice to figure out how the practicalities will develop.)  Maybe this aversion to going deep in the weeds is our bad – but certainly it can affect the overall tenor of the debate.

That said, here are four particular observations regarding the new section 385 regulations:

First, section 385 gives the Treasury VERY broad discretion.  So anyone who wants to argue that the regs are invalid is swimming steeply uphill.  It’s true that the regs address particular practices that were not specifically in Congress’s collective mind when it enacted the provision in 1969.  But the grant of broad discretion seems clearly to have been meant to let the Treasury respond to new developments.  Note also that this is not just an anti-inversion provision.

Second, one could see the regulation as a small and admittedly discrete move away from separate entity tax accounting for multinational groups.  Given the general economic significance (and potentially large tax significance) of the lines between legally distinct but economically integrated affiliated entities, this is a good direction to be going in.

Third, it’s important, and probably a good thing, that the regulation addresses “inbound” investment – i.e., U.S. economic activity by multinationals with a foreign parent – rather than just inversions.  A key reason for the inversion wave is that, in addressing profit-shifting out of the domestic tax base, the U.S. rules appear to over-rely on residence-based rules that apply only to U.S. multinationals, relative to rules that affect foreign multinationals.  This is a topic I’ll be addressing further in other settings.

Fourth, by acting unilaterally (here as previously) in response to the recent inversion wave, the Treasury has rejected old, 1980s-vintage notions of comity between the branches, by acting on a live and prominent policy topic rather than working with Congress via the design and enactment of new legislation.  But guess what – it isn’t the 1980s anymore!  We now live in a world where the tax legislative process has generally broken down, unless one party holds all the levers.  This is going to keep happening in the future, under both Democratic and Republican administrations.  Whether one regrets the lost 1980s of bipartisan legislation or not, that world is gone, and comity norms are going to change in consequence.  So one might as well get used to it.

2) Should the EC retroactively revoke rulings issued by the tax authorities of EU member states?  Are there better ways to address the concerns?  Is revocation consistent with US tax treaties?

It’s useful to look at this from an EU standpoint, just so one can understand what they’re about  Then there’s plenty of time to think about it from a US standpoint.

From an EU standpoint, it’s totally understandable that they would issue the “state aid” rulings requiring countries to take back favorable tax rulings that mainly had been issued to U.S. companies.  If the EC wants to restrain certain types of race-to-the-bottom internal competition between member states, it can’t let labels (such as the use of the tax system to deliver what are effectively subsidies) to lead to frustration of their policy!

Also, when one is adjudicating the merits of what has been done – in effect judicially, although the EC is a commission, not a court – of course it will apply “retroactively.”  Saying “Next time we’ll be really mad!,” and acting only nominally prospectively, would have been widely scoffed at, and would likely have failed to deliver a credible message to EU governments.

That said, from a US standpoint I am concerned about the degree of focus on US firms.  And I also understand that the EU structure makes it trickier for us to figure out how to negotiate individually with EU countries.  But that’s relevant to how we should respond – not to whether what they’re doing makes sense from their standpoint.

One last point, however – while the US doesn’t benefit directly – indeed, it loses – when a given US company (with mainly US shareholders) ends up paying more tax to EU countries, we may benefit indirectly in the long run, if it lowers the expected after-tax return to US companies from profit-shifting out of the US.

To put it differently, the EU may have affected its prospective tax-attractiveness, and this potentially benefits the US insofar as there is zero-sum tax competition at work between us.

3) Given the EC’s almost exclusive focus on US companies, should the US invoke section 891?

This provision permits us to double the tax rates on residents of foreign companies that subject US taxpayers to discriminatory taxes.  The apparent EU focus on US companies in the state aid cases has led some to urge that we consider invoking this provision.  (BTW, the chance that this will actually happen is probably about zero.)

I think of it this way.  In principle, bluffing is great, if one specifies in advance that it will actually work.  So if we threatened to invoke §891 and won valuable concessions of some kind from the Europeans, great.

But it’s hard to bluff effectively if you aren’t actually willing to pull the trigger.  And here I don’t think we should, plus the Europeans surely know that we won’t, plus there is also a downside to attempted Trumpist bullying.

So no, on balance we shouldn’t invoke section 891 or even waste too much breath pretending to think about it.

How should we respond, insofar as we’re seriously concerned about the focus on US companies?  I’d say, by doing something we might actually want to do anyway – doing more to address profit-shifting out of the US by EU (and other non-US) companies.

4) Is the US discussion of international tax reform disproportionately focused on “outward” investment by US corporations? What about foreign investment in the US?  Can the two be separated?
Is this in part what the §385 regulations are about? Should the US consider a US version of the UK “diverted profits” Tax? Should the US challenge supply chain structures and/or significantly broaden and tighten the earnings-stripping rules?

The inbound and outbound rules are closely conceptually linked.  These days, our main reason for taxing outbound is to address profit-shifting out of the US by US companies.  Likewise, our inbound rules address profit-shifting out of the US by non-US companies.
So it’s the same problem, just involving different groups of companies.  And of the two sets of rules get too out of whack, you get incentives for inversions, among other things.

The US rules may be too lax overall on profit-shifting out of the US – although that is legitimately debatable.

But what’s clear is that we’re more lax in this regard on inbound than outbound.  So even if we can do a better job addressing outbound by US companies, we need to bring those rules into balance with those for inbound investment.

Transfer pricing and earnings- stripping are the 2 obvious places to focus.

Finally, without endorsing the particulars of the UK diverted profits tax, it’s definitely an example of seeking to address domestic tax avoidance by non-resident companies.

5) Without any way to force members to sign on, is BEPS going anywhere? Will it become irrelevant? Will it make a meaningful contribution to the international tax rules or just cause disruption?

I’d restate the question as: Is the glass ¼ full or ¾ empty?

I expect BEPS’s true results to fall far short of the rhetoric and expectations.  I wish had a dollar for every speaker at every conference on OECD-BEPS over the last 3 years.  I’d be a rich man.  

From all that attention, you might think it would end up being a bigger deal than it actually is going to be.

But you can’t force members to sign on – views and interests differ – and the BEPS methodology, such as continuing to rely on separate-company accounting within affiliated groups, is a bit unpromising for BEPS.

That said, some real changes may indeed not just emerge but persist.  But the main thing is that, if the global tax policy climate has indeed changed, BEPS may be remembered as a harbinger or leading edge of this change, even if what really matters is that change, rather than its particular content.

6) If the US corporate tax rate on US multinational income is reduced, should pass-through entities help pay for the reduction?

Lowering the corporate rate ought to be fully financed.  Otherwise, we worsen the long-term budget picture and hand windfall gains to current investors, who are generally from the top of the income and wealth distribution.

Base-broadening (from an income tax standpoint) that applies to the pass-through sector as well as the corporate sector is the logical way to do it.  This obviously implies raising taxes for pass-throughs.

Is that so bad?  Well, I think it verges on making corporate tax reform a political non-starter. But it might not be so bad in substance for one very simple reason.  Recent research suggests that the partnership sector (although not sub S corps or proprietorships) is currently comparatively lightly taxed.  So the shift in taxes from the corporate to the pass-through sector might tend towards equalizing their overall tax burdens.

Two final points about broadening the base to pay for corporate rate cuts.  First, even if it’s revenue-neutral, it tends to hand a windfall to existing investment, at the expense of new investment.  That generally isn’t a great idea.

Second, Congress should look outside the budget window when it asks whether a change is fully financed.  Breaking even for 5 or 10 years based on one-time pay-fors is not good enough, if the change actually loses revenue in the long run.

Saturday, April 16, 2016

Another view of U.S. international taxation

I recently got to hear a non-U.S. individual who is a prominent tax lawyer abroad addressing international tax issues in the context of OECD-BEPS.  What he said was interesting, whether or not one fully agrees with it.

In his account, the U.S. decided long ago to treat its own multinational firms far more favorably than any peer country treats its multinationals.  The mechanism for this was permitting the U.S. firms to treat royalties that are foreign source income as active rather than passive (even though they generally are deductible in the jurisdiction from which one group members pay them out to other group members).  Thus, the royalties don't face either foreign tax or our subpart F rules, but accumulate tax-free in tax haven affiliates.  Peer countries, by contrast, would have taxed the royalties under their CFC rules.

The U.S. decision effectively to sacrifice any taxing claims with respect to its multinationals' foreign source income has led the EU countries to say: Maybe we should grab something here, since the U.S. has decided against taxing it.  Hence, OECD-BEPS, to which the U.S. has been invited - but not as a guest, rather as the meal.

This coming Tuesday, when I speak at the annual NYU-KPMG Tax Lecture on Current Issues in (International) Taxation, I strongly suspect that U.S. tax lawyers, with U.S. corporate clients, who are on my panel (a mid-afternoon "debate" session) will sing quite a different tune regarding how rigorously the U.S. treats its multinationals compared to peer countries, although not regarding OECD-BEPS.