The math appears to check out

Four or five months ago, I could hold two kittens in one hand.  Now I pretty much need two hands to hold one kitten (or else he'll dangle and struggle).  But their weight has indeed quadrupled since we got them.  (This photo is about two months old.)

Supreme Court foreign tax credit case

As long as I am writing blog entries that mention Supreme Court litigation, perhaps I ought to mention the pending case of PPL Corporation v. Commissioner, which concerns foreign tax credits, and thus seemingly is right up my alley.  But there is also a reason why I hadn't addressed it previously.

This case concerns an episode from the U.K. some years ago involving the privatization of previously government-owned public utilities.  Back in the 1980s, the Thatcher government pushed through a privatization, opposed by the Labour minority in Parliament.  The process resulted in huge profits to the initial investors, as in retrospect the initial stock price turned out to be much too low given the profits that the newly privatized industry quickly started showing.  (This may conceivably have been because of unanticipatedly great efficiency gains once the industry was in private hands, but the opposing story is that it reflected overly lax regulation - clearly a relevant issue in the realm of public utilities, and I don't know what the real story was).

Anyway, Labour came back into power in the early 1990s, having emphasized in its winning campaign that, while it would let the privatization of the utilities stand, it would enact a special windfall tax on the companies, relating to the (at least ex post) underpricing in the privatization process.  The windfall tax was duly enacted, and it used a formula that applied a multiple of average annual financial accounting profits over a four-year period to determine "value in profit making terms) that would tend be compared to the issue price.

U.S. multinationals that ended up paying this tax claimed foreign tax credits (FTCs) under U.S. income tax law.  But the foreign tax credit rules allow credits only for "income, war profits, and excess profits" taxes, and applicable Treasury regulations provide that a foreign tax is creditable only if its "predominant character" is that of an income tax in the U.S. sense.  This in turn depends on such features as whether it is realization-based (so a Haig-Simons income tax might not be creditable!), whether it starts from something that is close enough to gross receipts, and whether it then provides sufficient deductibility to suggest that it is aimed at net income.

The Treasury denied foreign tax credits, seemingly based in part on the formalistic concern that the levy didn't facially purport to be an income or even an excess profits tax, hence it didn't matter what someone might argue it actually was.  The Treasury won in one circuit and lost in another, and the Supreme Court decided to grant certiorari - taking on its first foreign tax credit case in more than 70 years - even though the particular tax at issue in this case matters only as to a handful of taxpayers.  I gather there is some possibility that the main game being hunted by the Supreme Court here pertains to administrative law (regulations versus case law, agency interpretation of regulations, etc.), but nonetheless the case could generate a precedent or dicta with subsequently influence on broader issues of foreign tax creditability.

There have been two academic interventions in the proceeding.  A group of tax economists, with Rosanne Altshuler holding the at least alphabetically derived pride of place, filed an amicus brief in support of the cert grant.  They urge that the Supreme Court uphold the creditability of the U.K. windfall tax, on the ground that it is economically equivalent to a creditable income or excess profits tax.  After cert was granted, a group of tax law professors, headed by Michael Graetz, filed an amicus brief in support of the government's position.  They urge that the Treasury's position be upheld, even though they agree that the tax bears an economic resemblance to creditable income taxes, on grounds worth quoting because I believe they have a certain force (whether or not one adopts their bottom line position):

"[S]ince the value of an income-producing asset necessarily depends on its earnings, a tax on value can be restated mathematically as if it were an income tax.  The idiosyncratic algebraic reformulation on which petitioner rests its entire case is only one of several equivalent mathematical reformulations, a number of which lead to the opposite conclusion that the UK tax at issue here is not a creditable income tax.  Petitioner would, in effect, have this Court extend the foreign tax credit well beyond its statutory scope of income and excess profits taxes to a whole host of taxes on value and perhaps even to consumption taxes, none of which have ever been creditable.

"Precisely because petitioner's reformulation would open the door to claims of foreign tax credits for foreign levies based on value, not income ... it would provide a road map to foreign governments, encouraging them to shift the costs of privatization to U.S. taxpayers by initially undervaluing public assets and companies and subsequently imposing a retroactive levy to compensate for the previous undervaluation."

Here's the problem.  Both sides are right, at least as far as they go.  The economists are right that this is a lot like an income tax, merely stated differently; and that form over substance (the easiest way to get to the government's bottom line) is generally something that one shouldn't want to rely on; and that the rationale for foreign tax credits at least arguably is at issue here.

But Graetz et al are right that the foreign tax credit appears designed to apply to some taxes (i.e., income taxes and their ilk) and not others that appear to be economically equivalent, other than in dimensions that have no obvious link to the question of whether a foreign tax credit should be extended or not.  For example, why should expensing, which could turn what was otherwise an income tax into a VAT-like consumption tax, be relevant to creditability?  What's the coherent reason for crediting foreign taxes but not property taxes, when the value of property may simply be a multiple of annual earnings?

E.g., suppose you own a foreign perpetuity that earns $5 per year, and that thus is worth $100 since the relevant discount rate is 5 percent.  A 40 percent foreign income tax is pretty hard to tell apart, other than in how it's formally stated, from a 2% property tax.  You pay $2 a year forever either way.

My forthcoming international tax book addresses the issue only to this extent: I criticize the FTC, which is a provision that strikes me as making no sense other than in the case of a reciprocal deal between two peer countries.  I note that a tool as powerful as the FTC (which offers 100 percent reimbursement of foreign tax expenses) is bound in practice to be equipped with lots of lots of bells and whistles that limit taxpayers' ability to have fun with it.  I further note that one of these limitations is the requirement that it be an income tax, but comment that the rationale for this particular limitation is unclear.

There's a fairly small literature in which a few good writers have done their best to try to rationalize the income tax requirement for the FTC.  But since the limitation results in distinctive treatment of foreign taxes that, as an economic matter, are rather similar, they've understandably had a hard time of it.

If one were thinking of the foreign tax credit in a reciprocal framework - although the U.S. enacted it unilaterally, and has never conditioned it on the other country's crediting our income taxes - one might be inclined to say: The reciprocal deal that the Congress happened to have in mind (at least implicitly, in pursuit of what is often the useful myth of "legislative intent") was just about income taxes, and not about them plus equivalents or near-equivalents in different clothing.  So it's like interpreting a contract, in which the parties agreed about A but not B, and we enforce their agreement as intended even though we think A and B are pretty much the same.

One background fact that I suspect helps to explain the filing of the economists' brief is as follows. In the 1990s, Bolivia wanted to enact a corporate cash-flow tax, but decided to enact a corporate income tax instead because the IRS told the Bolivians that the option they preferred would not be creditable. Yet it is hard to think of any good reason why the U.S. should have wanted to steer the Bolivians towards the one alternative rather than the other, an outcome which is bad for them without being discernibly good for us.

I am inclined to line up on the Graetz / pro-government side, but this reflects that I don't like the foreign tax credit as a policy matter.  However, if I were a judge deciding the case, I would have to spend more time than I have on the technical legal issue, concerning proper interpretation of the applicable legal authorities as written.

One last Fiona Apple (and John Lennon) comment

One last Fiona Apple comment here before I move onto other musical interests (whether or not I end up blogging about them).  I earlier offered Carole King as my 1960s-era comp for her, and that seemed logical enough at the time, but now I think that in some ways a better comp is John Lennon's classic 1970 Plastic Ono Band album.  This and Fiona's work have in common a certain rawness, tone, and personal set of topics often focused on bad things from the past, sometimes even extending to the sound, e.g., use of the piano (and I gather that she has called Lennon a major musical influence).

That said, Fiona's work is more musical and varied, and clearly (for my money) better overall than the Plastic Ono Band album, which reaches some great heights but also is plodding and dull at times.  While I have a high estimate of Lennon's musical gifts, they were actually more limited than hers for this genre.

And don't even get me started (as I seem to be transitioning here from a Fiona post to a John post) on Lennon's later solo work.  Take the song Imagine, which still stands today, more than 40 years after its release, as a true pinnacle of vapid soppiness.  Interesting to put that song on the same album as one that denounced McCartney for writing "Muzak to my ears."  And I more generally get the sense that Lennon must have vowed, when the Beatles broke up, that he would never again play with any good musicians, and that if perchance he did (since he was friends with several), he would make sure they didn't play well for him.  Even when he wanted to layer on a candy topping for his later work, extending through Double Fantasy, which at times he did, he seems to have lacked any particular flair for making it interesting.

It's clear in retrospect that his Beatles work heavily relied on the musicality that McCartney, Harrison, and George Martin were able to layer on top of it (although Lennon was a remarkably great guitarist despite his technical limitations).  But of course he contributed the core of intermingled candor, obliqueness, absurdism, and free-floating vitriol that still make his best Beatles songs seem like they were dropped in from another planet, even though they have been played endlessly for decades.

OK, back to Fiona Apple.  I look forward to her next album, perhaps in 2018 or so, and we will see whether she starts losing it with age as so many others have.

The main thing that I am eagerly awaiting at the moment is the Wrens' projected follow-up to their 2003 classic, The Meadowlands.

The problem with DOMA is discrimination, not states' rights

Not to look a gift horse in the mouth, but Justice Kennedy's apparent view, in yesterday's oral argument about DOMA, that it might be unconstitutional based on states' rights, strikes me as really weak (and I am restraining my impulse to offer a more vitriolic description).  I will be glad if he supplies the fifth vote to overturn DOMA, and if he wants to do it this way, rather than invoking discrimination, I suppose one should be glad overall.  (Just as, in the healthcare litigation, I was glad that Chief Justice Roberts found a way to uphold the law, although I considered it completely ludicrous to view the mandate, unlike Medicare's far more aggressive intervention in the healthcare market and people's choices, as beyond Congress's commerce clause powers.)

But still, if Kennedy ends up supplying the fifth vote in a separate opinion relying on states' rights - and I realize that I may be jumping the gun in assuming that he will - it's worth noting how intellectually flimsy his avowed stance would be.

Let's put the apparent Kennedy position this way.  He appears to be inventing a new constitutional provision called the Reverse Supremacy Clause.  Under this fictional clause of the U.S. Constitution, once the states have expressed their policy judgment in a particular area, the federal government is constitutionally bound to accept that judgment, and cannot reach a different one on the same issues when it is designing federal legislative programs such as Social Security, Medicare, and the federal income tax.

OK, so all 50 states plus the District of Columbia have this legal status called marriage.  It matters for various state law purposes, such as property rights and the operation of  rules governing the workplace.  The states do this based on policy judgments responding to the fact about human beings that we often form family or household bonds involving couples.

The federal government also has various rules that make policy judgments regarding the legal significance under various programs of such couples or families or households as it chooses to recognize.  For example, the income tax requires joint returns (or use of the married filing separately route, rather than single or head of household) for individuals who are married, a determination that generally is made under state law.  Likewise, Social Security and Medicare offer certain spousal benefits.

Certain transfer programs that provide aid to the poor look beyond state law marriage to assign legal consequences to other measures of couple or household status.  And federal immigation law, I gather, disregards state law marriages that it classifies as shams, without any implication that it is adjudicating the state law validity of these marriages.

For that matter, there is an amusing federal income tax case, I believe from the 1970s,involving a couple that got divorced every December and remarried early the next year, using the tax savings from not having to file a joint return to fund a nice vacation.  For federal income tax purposes, the divorces were held to be sham transactions, and thus the two individuals were required to file jointly or as marrieds filing separately.

OK, so suppose Congress were to say: We favor joint filing for certain types of couples, but we want to define the relevant couples in our own way.  So we will count, say, everyone (and only those people) who (1) are cohabitants for at least 6 months out of the year, (2) commingle their funds or their consumption expenditures in a non-arm's length manner, and (3) are deemed to have some sort of requisite state of mind regarding their relationship.  Perhaps the legislative history might add that state law marriage is evidentiary of whether one is in a couple for federal income tax purposes, but that any resulting presumption can be overridden by factors A, B, and C.

This law might be administratively unworkable, but can anyone seriously maintain that it would violate states' rights?  Why can't Congress define couples as it likes, solely for purposes of federal programs?  When the states decide how to define legally relevant couples for purposes of their own rules, do they really take away Congress's discretion to do the same thing for purposes of its rules?

But then we get Justice Kennedy saying that “The question is whether or not the federal government, under our federalism scheme, has the authority to regulate marriage.”  The only alternative I see to viewing this as an invocation of the fictional Reverse Supremacy Clause is to say that he is applying some sort of unrationalized "all or nothing" rule, under which, if Congress chooses mainly to rely on state law definitions, it can't selectively depart from them.

But how can one possibly defend that view, leaving aside the discrimination problem?  Why shouldn't Congress be able mainly to rely on state law marital status most of the time (thus reaping significant administrative benefits), but modifying the relevant definition for federal purposes however it likes, so long as it is advancing legitimate federal policy objectives?

Needless to say, the problem with DOMA - and the reason I would vote to hold it unconstitutional - is that the distinction it makes, in determining which couples to recognize, is discriminatory and does not advance a valid federal purpose.  But this has nothing to do with the fact that it otherwise relies on state law.  Similarly, Congress could not constitutionally deny Social Security benefits to interracial couples, whether the definition that it otherwise applied was based on state law or on the hypothetical scheme that I set forth above.

Tax policy colloquium, week 8: Leslie Robinson's "Internal Ownership Structures of Multinational Firms"

On Tuesday, Leslie Robinson of the Tuck Business School at Dartmouth presented the above-titled paper, co-authored with her colleague Katharina Lewellen, and available here.

This continued our annual tradition of having a paper by an accounting professor (we also try to do one each year by a political scientist, this year to be Larry Bartels on April 23), along with some economists, a mix of junior and senior law professors, and often a tax practitioner. 

The paper looks at multinational firms' internal structures.  In particular, when do they have "complex" structures in which, rather than having the U.S. parent directly own, say, a sub in every country where it operates (this would be a "flat" structure), they have tiered structures in which some subs own other subs.  The aim is to get a sense, from the overall empirics regarding "owner subsidiaries" and the particular vertical pairings that one finds, regarding what might be the likely causation, be it tax or something else, for internal complexity.

One unfortunate limit in the data is that one can't observe which firms are "hybrids," i.e., firms that the taxpayer elects to treat for U.S. tax purposes as legally non-existent branches of their direct owners.  Hybrids are useful so that one can, say, pay interest from a Germany subsidiary of an ultimate U.S. parent into the Caymans for German tax purposes, without the U.S. thereby saying: Aha, receipt of interest by the Caymans affiliate means that the U.S. parent has subpart F income.

The paper finds evidence of both tax motivations and others in the use of complex internal structures.  But a lot of the others were probably also tax.  For example, affiliates that trade with each other often have a vertical ownership structure.  But those dealings may be tax-motivated transfer pricing.   And affiliates with a lot of cash on hand tend to invest equity in other affiliates.  But they may have had cash on hand due to profit-shifting games within the group, and then they use the cash to own other affiliates directly so that it doesn't have to be repatriated taxably to the U.S. parent first.

A natural policy response would be to entirely ignore internal structuring of multinational firms, and tax the entire global entity (whether it has a U.S. parent or not) as a unitary business.  For U.S. firms, this could involve replacing deferral with a lower tax rate for foreign source income generally (since the question of what tax rate we want to impose on foreign source income is distinct from that of whether internal firm structure should matter).  It might also involve wholly ignoring intra-firm cash flows of all kinds (who borrows from each other or a third party lender, who pays royalties to whom, etc.).  This would put us in a formulary apportionment world, which isn't ideal either.  But I see that (if done right) as a way of making the effective election to shift profits costlier than it is when we take account of meaningless intra-firm entity lines and events.

A different type of response would be to tax-penalize complex structures directly, on what I call the Three Stooges rationale.

(Moe hits Curly on the head.  Curly: "Whatja do that for?  I didn't do nothin'!"  Moe: "That's in case you do something later when I'm not around.")

This could either involve directly relating U.S. tax burdens to some measure of complex rather than "flat" internal structuring, or more consistently giving adverse tax consequences to intra-group cash flows, including those that use hybrids.  The corporate literature on "pyramiding" and responses thereto may be of interest here.

Free at last (!?!?!?!?!)

I have just completed what might be a full draft of my book-in-progress, Fixing The U.S. International Tax Rules.  It took 4 years and 4 fresh starts - whereas usually, once I have a book clearly in mind, I can write it in a few months.  The total damage is about 100,000 words, which is perhaps a bit on the long side.  But even at that length, there were a number of topics that I needed to keep fairly brief.  It is much more directed to how we should think about international tax policy than to pitching a particular solution, although I do try to relate the ideas discussed to concrete implementations.

It's not quite a completed draft just yet, as I need to read the whole thing over again, with an eye to its unity, consistency, and non-repetitiveness, among other key attributes.  The constant reloads and start-and-stop character of the process make this especially necessary, although they have also induced me to do a lot of re-reading and editing as I went along.

I'll be presenting the book at a conference in Hebrew University this June.  (My 3 discussants are probably glad to know that they will see it soon.)  And I have not as yet committed to a publisher.  I won't be posting it on SSRN, but hopefully it will be out as soon as 2014.

Some, but not all, of what I consider its more novel aspects are foreshadowed in articles that I have published over the last few years on foreign tax credits and U.S.corporate residence electivity.  But I have rethought some of the ideas in those articles, and the book is almost 100% new work, as opposed to being a cut-and-paste job.

Tax policy colloquium, week 7: Desai and Dharmapala's "Competitive Neutrality Among Debt-Financed Multinational Firms

On Tuesday we did our last Tax Policy Colloquium before NYU's one-week spring break.  Our speaker was Dhammika Dharmapala, presenting a draft of the above-titled work that he and Mihir Desai are co-authoring.  No link here, as he asked us to take it down afterwards because it is still in very preliminary form.

A bit of the abstract may help to explain what issues the paper tackles and what conclusions it reaches.  For starters:

"Debt plays an important role in the financing of multinational corporations (MNCs). Interest expenses are typically tax-deductible in most corporate income tax systems, and there has been a growth of interest in recent years in the tax treatment of debt and its consequences. This paper discusses the optimal form that interest deductibility and associated restrictions should take in a multi-jurisdictional setting. We straightforwardly extend existing neutrality norms in international taxation to serve as a benchmark."

They use "competitive neutrality" as their benchmark, but they could just as well have used "capital ownership neutrality" (CON), which Desai in particular has written about before (along with Jim Hines).  For convenience, I will characterize them as using CON even though they keep on saying "competitive neutrality."

I must confess to not being happy with this approach, for reasons that my forthcoming international tax book will explain in more detail.  Complaint 1: It's a global welfare norm, and thus not necessarily of interest to policymakers (or citizens) in any particular country.  I think the way to go is by starting with unilateral national welfare (i.e., what's best for the particular country that is setting its rules for inbound and outbound investment, if no other country responds to its choices), and then asking how strategic interactions with other countries may change the analysis.

If you instead identify a best approach from the global welfare standpoint, it's conceivable that countries could execute a Pareto deal to achieve it, leaving everyone better-off.  Conceivable, but not too bloody likely.

OK, in principle it doesn't matter where you start, so long as you end up in the right place.  So why not begin with global welfare, as Desai and Dharmapala do, and then proceed towards national welfare by examining opportunities for cooperation?  But the problem is this.  As the paper shows, there are just so many margins that one could think about, in trying to maximize global welfare, that starting there almost inevitably lands one in a morass.  National welfare turns out to be simpler, or at least more readily simplified for basic analytic purposes, most of the time.  But again, that's jumping into my book and would need fuller illustration than I can provide here.

In their colloquium paper, Desai and Dharmapala are interested in particular in the question of how CON plays out when it is impossible to achieve accurate "tracing" of interest expense to the outlays that are related to them at the margin.  So you have the basic scenario that a taxpayer can, say, borrow in a high-tax country and invest the funds in a low-tax country.  This can cause negative-present-value projects on a pre-tax basis to make a whole lot of sense (from the taxpayer's perspective) after-tax.  Under CON, they want to achieve global tax neutrality for all multinationals with respect to the question of who borrows (anywhere) in order to hold a particular asset (somewhere).

The paper concedes that there are other relevant margins, such as those pertaining to the choice between debt and equity and to the choice of negative-present-value projects.  But they want to isolate the CON thread for separate analysis, on the view that this is worth knowing even if in the end one will have to optimize overall at all of the margins, which probably requires failing to fully optimize at any one of them considered in isolation.

More damaging still, in my view, is the fact that this is only CON between multinationals.  They concede that their approach might result in tax bias as between multinationals and purely national firms.  For example, suppose GE and an Indonesian firm would both pay tax on factory production in that country at the Indonesian rate, but that only GE can borrow in such a way as to get interest deductions at the higher US rate, rather than the Indonesian rate.  You could then get the scenario where GE is tax-favored relative to the Indonesian company.  In such a case, satisfying CON for their purposes, by reason of treating, say, GE and Siemens the same, might be an empty achievement.

OK, one might argue that GE and the Indonesian firm are likely to be active in different sectors, and thus not competing directly.  But even apart from the fact that these two sectors may be competing for global capital, suppose GE wants to use the Indonesian firm in its global production processes, and is deciding whether to buy it or use arm's length contracting.  CON as used in the paper therefore appears to fall quite short even apart from its being just one of many global efficiency strands and its not being of direct interest to any national policymaker.

Putting out of mind (for just a moment) all those limitations, where do they believe it leads?  They note that, generalizing the approach taken in a rather notorious paper on interest deductibility by Jim Hines, suppose the U.S. agreed to provide 35 cents of subsidy per dollar of interest expense by all multinationals investing anywhere in the world.  That would achieve CON, but it doesn't appear to be politically feasible (gee, I wonder why).  So they look at alternative approaches, including one in particular that they expressly describe as a thought experiment rather than a concrete proposal.

Suppose that all countries in the world agreed to impose a worldwide debt cap that functioned as follows.  While in general each multinational's affiliates in a given country would deduct their in-country interest expense, all countries would impose a worldwide debt cap, restricting the amount of the in-country interest deductions to the multinational group's total worldwide third-party interest payments.  Desai and Dharmapala argue that this would satisfy CON (in the between-multinationals sense) so long as the multinationals had enough taxable income in each country where they borrowed to deduct all of the locally incurred interest expense.

They concede that this might both create a huge global tax bias in favor of debt at the expense of equity, and make negative-present-value projects worth undertaking after-tax.  But they argue that one could address those concerns, without undermining the CON result, by having all countries agree to cap the allowable interest deduction at the same arbitrary fraction of global third-party interest expense.  Hence, at least for thought experiment purposes, they appear to regard their proposal as potentially meritorious across all of the relevant margins, so long as policymakers around the world pick the same arbitrary fraction in light of the proper weight of all the competing objectives.

While the proposed thought experiment solution is not unclever, I in the end can't help but regard the paper, with all due respect to its authors, as very effectively (though inadvertently) illustrating the argument in my forthcoming book that much of the international tax policy literature has gone badly off the rails.  I am skeptical that "alphabet soup," or the use of a single-bullet global welfare approach to guide the analysis, can lead anywhere that is very useful, no matter how intelligently it is executed.  And when I say "useful," I mean either in the sense of leading to important theoretical insights or of generating practical proposals that policymakers might find useful.  I hope and even believe that very different types of approaches to international tax policy analysis will become increasingly prevalent over the next few years.

Corporate tax reform?

In an earlier post I expressed both political and substantive skepticism about the current prospects and merits of 1986-style individual income tax reform, which would feature lowering the rates in exchange for broadening the base.  But there has also been much talk about doing this just in the corporate income tax.  Does that have greater merit?

Let's start again with the political feasibility question, then turn to the actual merits.  I am skeptical about this one's prospects as well, though not for exactly the same reasons.  Starting with the partisan political environment, I actually find it plausible that House Ways and Means Chairman Camp could come to an agreement with the Obama Administration, if they were the only principals.  But since they are not, the general stance of the Republican Congressional leadership is inevitably part of the equation.

But there's a bigger problem.  What does the deal look like, even if they have a common vision and are prepared to deal?  Taxation of the U.S. business sector is unusual, compared to that of our peer countries, because of how it is split between the corporate income and the individual income tax (the latter for partnerships, S corporations, proprietorships, and LLCs that elect to be taxed as partnerships).  So if you broaden the base to pay for lower corporate rates, while keeping the rest of the tax system the same, you must either actually raise taxes in the non-corporate business sector or have the tax treatment of the same item (e.g., depreciation) differ between the sectors.  Plus, disparities in how much the shareholder-level part of the corporate tax actually matters make it difficult to decide how one could be aligning everything neutrally.

Now to my skepticism about the merits.  The U.S. corporate income tax is a compound beast.  It contains a lot of separate elements that, in principle, we would want to tease out and treat distinctively, but we don't and in some cases can't, once we have an entity-level tax that gloms them all together.

What is the core reason for wanting to lower the corporate tax rate?  The answer is global tax competition.  What we have in mind here, above all, is mobile capital held by foreigners who can invest wherever they like.  Under "small open economy" assumptions about their investment opportunities in the U.S. we might actually want to tax their earnings here (other than rents) at zero.

But that is only one piece of the U.S. corporate income tax base.  A second is mobile capital held by U.S. individuals.  They, too, can invest anywhere.  But in principle, under the worldwide residence-based individual income tax, we ought to be able to require them to pay U.S. tax no matter where they invest.

In practice, this is not so easy due to the realization requirement and their ability to invest abroad through non-U.S. entities (although the passive foreign investment company or PFIC rules should catch them when they hold a foreign stock or bond portfolio through, say, a Caymans entity).  But we certainly have good reason to want to apply the full U.S. rates to income that they earn through a corporate entity, including when it's a U.S. entity and/or it earns U.S.-source income.  So for them we want a higher rate, but you can't have the tax rate in an entity-level corporate income tax depend on who is the owner.

Then a third element is labor income that U.S. individuals earn through corporate entities.  This is the issue of owner-employees under-paying themselves, and here we definitely want to charge the full U.S. rate.  But we automatically lose this, if we lower the U.S. corporate rate, unless we adopt tough associated reforms such as a Scandinavian-style "dual income tax."

So what ought the U.S. corporate rate to be?  The answer is, it should be different for each of these elements, and also different depending on how we evaluate the burden of shareholder-level taxation (which may end up being zero for people who wait for basis step-up at death, but for others may be significant).

The point here is not that we definitely shouldn't lower the U.S. corporate rate, but that it's a complicated question because we should as to some elements and shouldn't as to others, yet in effect must pretend that one size fits all, at least in the absence of other changes that I don't believe are really on the table.

Now let's briefly consider the pay-fors.  There is certainly some garbage in the U.S. corporate income tax base that it would be great to get rid of (although arguably the revenue gain should go to lowering the long-term U.S. fiscal gap).  But consider, say, accelerated depreciation.  While cost recovery disparities create inter-asset distortions, it's not all bad to have the system closer to a consumption tax rather than an income tax base, in terms of incentives for new investment.  And as a transition matter, if we lower the rate and pay for it by slowing down depreciation, then to a degree we have combined a windfall gain for old investment (which deducted accelerated depreciation at a higher rate and now gets to include the associated income at a lower rate) with what is effectively anti-stimulus for new investment in the middle of a continuing jobs crisis.

Gary is a basketball fan

He appears to be quite interested in the Knicks-Thunder game.

Skepticism about "fundamental tax reform"

Today we had a special lunchtime event at NYU Law School.  Victor Thuronyi of the International Monetary Fund, an old friend with whom I worked on the Tax Reform Act of 1986 (he was on the Treasury staff, while I was at the Joint Committee on Taxation), discussed his plan for enacting a "supplemental expenditure tax" (SET) as part of an overall tax reform plan.  The SET is basically a consumed income tax, aka an individual-level cash flow consumption tax, that he would use to pay for rate reductions in the existing income tax.  You can read about it here.

I myself find it easier to imagine a VAT being added to supplement the income tax than as SET (as in the Michael Graetz tax reform plan).  But I question the premise that both Thuronyi and Graetz advance, to the effect that the revenues raised by the new tax should be "spent" on reducing income tax revenues.  Considered in isolation, that might be a good idea, but what about other budgetary uses for the funds when we appear to have a long-term fiscal gap to worry about once the horrible employment situation of the last few years has passed into history.

But both plans are certainly welcome as expansions to the list of ideas that are people are talking about.

I was a commentator at Victor's session today, as was David Miller, and here is a fleshed-out portion of the part of my remarks in which I addressed, not so much Victor's plan as such, as the issue of whether we need 1986-style "fundamental tax reform."  This, of course, is a topic that I have also addressed here.

Shaviro remarks (3/6/13) on 1986-style "fundamental tax reform"

Everyone loves tax reform in theory, though not so much in practice. And of course tax policy types tend to love it, and why wouldn’t we? But I want to verge on heresy by throwing a bit of cold water on the idea.

Obviously I’d like to “reform” the tax system, in the sense of changing it to be better. And there is so much wrong with the current system that identifying things we could improve is a bit like shooting fish in a barrel.

But I have become a real skeptic about what I call 1986-style tax reform. Let me first define it, then say why I have become so skeptical about it.

1986-style reform typically involves lowering the rates and broadening base, under a constraint of maintaining revenue neutrality and distributional neutrality relative to prior law. By the way, in 1986 the top group for purposes of assessing distributional neutrality was people with income of $250,000 or more.  Today, even adjusting for 27 years of price-level changes, we might want to look distinctively at much higher-up groups (such as the top 1%, 0.1%, and 0.01%).

In 1986, I agree that this tax reform model was a good one.  The parties disagreed about the revenue and distributional parameters, but were capable of agreeing about some other stuff. So they did what they agreed about, while agreeing to a ceasefire in place for the rest.  Note, by the way, that the top rates they were lowering rates were 50% and 46% for corporations - considerably above where we are today.

Today, I don’t see the politics working as well, for two reasons.  First, the relationship between the parties is obviously very different than it was in the mid-1980s. But second, consider what Congressman Richard Gephardt notoriously said in 1986 (as quoted in the subsequent Birnbaum-Murray book, "Showdown at Gucci Gulch."  Biographical note: Gephardt was a cosponsor of the well-known Bradley-Gephardt tax reform plan, but then went completely MIA when the 1986 Act started marching towards enrollment,  Anyway, he said: “It’s not that good an issue.” And he was right as a political matter.  The 1986 Act only went through, despite widespread public hostility or indifference, due to what economist Henry Aaron called the "dead cat" problem.  None of the main leaders responsible for shepherding it through (President Reagan, James Baker when he became the Treasury Secretary, Dan Rostenkowski in the House, or Bob Packwood in the Senate) wanted the "dead cat" of having killed tax reform on his doorstep.  Even though the public disliked the tax reform bill, it was all too ready to assume that anyone who killed it was a tool of the interest groups and/or an ineffective leader.  So the political dynamic worked, but it was a very odd one and hard to replicate.

That's just about the feasibility of 1986-style reform, which flies in the face of the political science maxim that concentrated special interests tend to beat out diffuse general interests.  But again, perhaps so what.  Here are several reasons for being, at a minimum, only mildly rather than greatly upset (and, in some cases, affirmatively relieved) if 1986-style reform doesn't happen:

(1) Let’s not exaggerate the benefits.  At a first approximation, if you broaden the base but lower the rates, work incentives are the same as before.  The economic payoff is to distortion between rival consumption and/or investment choices.  That can be a nice payoff, but it doesn't, for example, project to greatly increased ecnomic growth.

(2) Complexity costs for average individual taxpayers, which these plans often seek to reduce (e.g., by repealing the alternative minimum tax) often are not as great a concern as they used to be.  Two words (or is it actually just one?): TurboTax.

(3) 1986-style reform often treats a high rate and a broad base as substitutes. You use revenue gain from the latter to buy out of the former.  Economically speaking, however, they are complements.  The broader the base and thus the harder the tax is to avoid, the lower the efficiency costs of having a higher rather than a lower rate.

(4) What does it even mean to say, 1986-style, that revenues will remain the same? Given the point that targeted tax breaks serving allocative purposes may (more or less rightly) be viewed as tax expenditures, any such claim is based on form, not substance.  It might be more accurate to say that both "taxes" and "spending" have declined (although these terms aren't very meaningful to begin with) if we, say, repeal the home mortgage interest deduction to pay for lower rates.

(5) Should everything have the same tax rate?  The theory of optimal commodity taxation explains why the answer to this question is no under realistic parameters that are relevant here. Rather, unless you've done more fundamental reform, items that are more elastic typically should be taxed at lower rates than those that are less elastic.  The revenue-maximizing rate for capital gains, at least under present law (with a realization system and tax-free basis step-up at death) is probably below 30%.  That for wage income may be a lot higher.  Or consider the argument that, so long as we have an income tax that's collected at the entity level for income earned through a corporation, the corporate rate should be lower than the individual rate.  (This reflects the fact that corporate income is a proxy, albeit an imperfect one, for globally mobile capital.)  Finally, consider the argument I will make in my forthcoming international tax book that the optimal U.S. rate for foreign source income of U.S. companies is lower than the domestic rate, even if not so low as zero (as it would be under a territorial system), and that everyone kind of knows this although plenty of people (including experts) confuse themselves by relying on the foreign tax credit to lower the effective tax rate on the foreign source income.

(6) Given the long-term fiscal gap that we face, it's questionable whether we should do a whole lot of heavy lifting in our tax system design that has zero net payoff in terms of returning to sustainability.  In addition to diverting scarce "reform capacity," a 1986-style might give away "low-hanging fruit" by "spending" the budgetary gain from base-broadening (or new taxes such as the VAT or SET) on wish lists other than restoring long-term sustainability.

(7) If you are concerned about high-end distribution, why would you want to cut the top individual rate?  Arguably we should be thinking instead about increasing it.

Tax policy colloquium, week 6: Darien Shanske's Modernizing the Property Tax

Yesterday at the colloquium, Darien Shanske of the University of California at Hastings Law School presented his paper, Modernizing the Property Tax.

One great thing about the paper and the topic was as follows.  I have been doing the colloquium for 18 (!) years now.  At this point, it's pretty rare to get a new topic or something I haven't seen come down the pike before.  But this was pretty novel for me - probably our first real property tax paper ever, and Darien is effectively using his energy and imagination to reinvigorate a topic that for decades has seemed moribund.  So I very much welcomed and enjoyed this.

Herewith some thoughts about two of the main sets of issues that the paper raises:

1. ARE REAL PROPERTY TAXES A GOOD LOCAL FINANCE TOOL?

Paper likes them & wants to reverse their decline. E.g., it argues that they nicely correct for the federal income tax exclusion of imputed rent. Renters are taxed at the federal level, homeowners at the local level through the real property tax, & this division of the tax base could make sense as fiscal federalism.

I’m skeptical both about this division-of-the-tax-base claim & about the general merits of the real property tax at the local level.

Some points to the contrary:

(1) Since the local real property tax reaches ALL real property, arguably it fails to adjust for the federal imputed rent exclusion. E.g., it doesn’t address the home vs. rent disparity. Both pay at the local level, even & the incidence of the local real property tax is probably on renters).

So renters, unlike homeowners are taxed at both levels, & the federal disparity may not be reduced by local real property taxes.

Likewise, home use vs. non-residential use of real property isn’t addressed by subjecting both to local real property tax.

(2) Suppose the real property tax is a pure benefit tax at the margin. E.g., an extra dollar of tax means an extra dollar of garbage pick-up or other local amenities. Then it’s not really a tax, but a service fee, and again charging it at the local level does nothing to offset the federal exclusion.

(3) We may like the Tiebout-type benefits of local taxes. But these don’t require that the tax be directly on real property. Anything that’s tied to residence will do. E.g., consider income taxes that the state collects on behalf of the locality, on top of its own income tax (a la New York State and NYC / Yonkers). Not clear that this is less of a benefit tax at the margin than a real property tax, in which not just site value but also the value of improvements is being reached.

(4) Paper likes the local property tax for salience of the tax-benefit link. A la Tiebout, but operating through voice rather than exit. But why wouldn’t a local income tax that the state collects & remits for the locality work the same way? And with the real property tax, when the owner isn’t a resident you probably lose the political salience point. E.g., even if renters bear the tax, they don’t see it listed as a specific item, whereas they would be able to see the local income tax as a separately listed item.

(5) OK, there are 2 things I like about the real property tax. First, the locality can collect it by itself. But note what a bad job they tend to do with valuation. Second, a tax on site value has elements of being a lump sum tax that isn’t distortionary, if owners can’t affect site value. But taxing the improvements still is narrow & distortionary.

SO: I’m left with little reason to mourn the relative decline of the real property tax, & perhaps little motive to restore it to its formerly higher relative level. 

2.  DARIEN'S PROPOSAL

I will emphasize 3 of his proposals in particular. Note that they are largely distinct (i.e., could be adopted or not separately).

(1) Monthly property tax withholding that isn’t just through escrow for people with mortgages, but for everyone and chiefly through employment.

(2) Liquidity insurance: current real property tax liability is reduced when income declines, including from pre-planned retirement rather than surprise job loss. The avoided taxes are due with interest when you sell.

(3) Retrospective revaluation: when sell, assume value change from purchase price occurred ratably, and re-determine past year’s property tax liabilities. E.g., buy for $100K, sell in 3 years for $133.1K. This is 10%/year, so assume the value was $110K, then $121K. If a positive adjustment, collect with interest at closing. Can ratably impute negative as well as positive returns.

I question the first two, but I mainly like the third.

My responses:

(1) While moving towards monthly rather than annual payment may generally be good, escrow already covers 60% of homeowners, tilted towards those who most likely to be cash-constrained and/or to need help managing their cash flows.

(2) I question shifting this task to employers. Not just a burden they may not want, based on information they don’t automatically have, but also the employee may not want to share this information with them. Paper notes problems such as states without an income tax & commuters between states. When you add this to people who aren’t employed (including retirees), could be a mess.

(3) I question the liquidity insurance feature. Distinguish 2 situations: unexpected shock such as losing your job, planned step such as retirement.

For the former, there is generally a case for cushioning the downturn, due to the rigidity of pre-planned spending patterns. This is what unemployment insuranc purposese (UI) is all about. But why have such a program apply distinctively for real property tax? And note the efficiency tradeoff that UI generally involves (other than in the current down economy) since it increases incentive to lose job & reduces incentive to find a new one.

For retirement, I don’t see the rationale at all. Why “insure” against a planned & deliberate act? Note that the proposal might also strengthen the tax incentive to retire, or perhaps even to move to high-property tax communities when you retire.

Part of the paper’s rationale for the liquidity insurance is political economy – e.g., local residents who are seniors opposing funding for local improvements or schools. But this may reflect their self-interest, not just liquidity concerns.

(4) Under both liquidity insurance & retrospective revaluation, I’m concerned about the plan to collect amounts due at sale. Can lead to default / liquidity problems if loan to value ratio is high. Note also that people often want to reinvest by buying a new home. So this proposal is anti-smoothing, whereas the first proposal is pro-smoothing.

(5) Otherwise, I mostly like retrospective revaluation because it’s objective market evidence in a very flawed process. But 2 quick comments:

--Is extra tax due upon sale the usual case? Paper sometimes appears to assume this. But it depends on assessed value vs. actual value. Today perhaps a practice of under-valuation, as a way to curry favor with local voters or due to Proposition 13-style limits. But the new rule might encourage states to value high rather than low, figuring it solves the default problem & that they can say: don’t worry, you’ll get your money back.

--If TPs are myopic or don’t consider the tax inevitable or would face a liquidity crunch upon sale due to the maturation of deferred tax liabilities, the end result may be increased lock-in. Whereas Proposal #1 makes real property tax payments smoother, this may make them less smooth.

There and back again

I've just completed taking seven airplane flights in five days, and all of them were on time.  I guess the sequester wasn't an immediate problem for air travel after all.  (Perhaps due to the 30-day requirement for furloughing airport personnel.)  Or, per my prior post on the topic, I suppose the travel gods were still satisfied with the 2-day layover they had handed out to me when I was in Los Angeles at the start of February, and decided to let me off easy this time.

But just by a hair, as it happens.  If today's weather in the Midwest had gotten there a day earlier, I might still be stuck out there, fuming and/or cooling my heels (if one can do both simultaneously) as another winter storm rages through.  That would have caused me to miss today's NYU Tax Policy Colloquium, where we are discussing Darien Shanske's paper, Modernizing the Property Tax.  More on that, of course, in a subsequent post (since, just to get the counter-factuals straight, I am in fact back here).

How do you get into the position of taking 7 flights in 5 days?  It's quite easy, actually.  All you need to do is accept two speaking gigs within a few days of each other, neither of which is reachable from New York (or the other place) through a direct flight.  So, starting in New York last Thursday, I first flew through Atlanta to Tallahassee, where I presented my Henry Simons paper last Friday at the FSU Law School's 100 Years of the Income Tax conference.  On Saturday I then flew through Atlanta and on to Chicago.  On Sunday, I did the final outbound leg, to Champaign, IL, where on Monday I presented this year's Anne Baum Elderlaw Lecture at the University of Illinois Law School.  The lecture was based on my paper, Should Social Security and Medicare Be More Market-Based?  Then last night I made it back to NYC through Chicago.

The slides for my Simons talk in Tallahassee are here.  In case anyone is keeping score, they have been slightly revised, not only since I posted an earlier version for my USC talk on Simons, but also since I gave the talk at FSU.  The slides had a couple of small errors that I decided to fix.

I'm not sure if I should consider this a compliment or not, but a commentator at the FSU session, praising the Simons article's literary style, compared me to a skillful nurse-practitioner who is giving you a shot, and who manages things so smoothly that you don't even notice it when the needle goes in.  OK, it was all in good fun, but I am not sure what he meant by the needle.  I am straight-up in my academic writing.

The slides for my Social Security / Medicare talk are here.  This is a first-time posting.  While the slides have a lot of content and were made for a one-hour talk, they are certainly a quicker read than the article, and cover most of the same bases.

Both the slides and the paper for my Social Security / Medicare project, while perhaps less fun than the Simons project, exceed it in analytic content.  The Illinois paper is also more relevant to current policy debate - for example, the battle over Medicare design (traditional system versus Ryan plan) that played a major role in the 2012 presidential election.

Not to whine here, but I get the sense that my work on Social Security and Medicare (as well as on budget deficits) gets less attention than when I am writing about the income tax or tax reform.  People evidently find it less credible that one with my biography and public credentials would be adding value on those topics than when the issue is straight-up tax.  But the issues are really all fundamentally of the same character (apart from the fact that I make no claim to be a healthcare expert). So please read up if you are interested, although I don't mean to beg.