Wednesday, April 30, 2014

Gamage, Framework for Optimal Choice of Tax Instruments, part 2

Here is Part 2 of an adapted version of my notes for yesterday’s session discussing David Gamage’s “A Framework for Analyzing the Optimal Choice of Tax Instruments.”


Again, the paper suggests using all of a labor income tax, VAT, capital income tax, wealth tax, legal rules, plus perhaps more (subject to administrative costs) to address distributional issues.  But the argument is based on avoidance costs – not on how distributional outcomes should relate to underlying “true” information about, say, individuals’ ability, earnings, savings, or gratuitous transfers.

One can explain the paper’s main argument in two complementary ways.  First, suppose that potentially useful tax instruments tend to have a rising marginal cost of public funds (MCPF) as we start using them more.  MCPF is basically deadweight loss per dollar of revenue raised, adjusted for the social value or disvalue that is associated with a given outcome’s effect on after-tax distribution.  As you use any instrument more, the ratio of deadweight loss to revenue will tend to increase.  For example, doubling the tax rate may tend to quadruple the distortion.  Likewise, increasing audit rates, if the potential audits are ranked by expected payoff, means adding ever less fruitful new targets.  Keeping distribution constant, the aim is to equalize the ratio of deadweight loss to revenue raised at the margin for all instruments.

Second, and more distinctively, the paper distinguishes what it calls single-instrument vs. multiple-instrument tax avoidance.  Here the focus is on taxpayer actions to reduce tax liability.  This could involve, for example, reducing your labor supply, altering your mix of consumption or investment choices, or paying lawyers and accountants to work their magic for you.

Tax avoidance presumably has rising marginal costs per dollar of tax avoided.  For example, working (and thus earning) just a bit less than you’d prefer, taxes aside is not so bad, but working and earning a lot less starts to get really painful.  Or, the tax planners get the low-hanging fruit first, but then it keeps getting costlier to avoid the next dollar of tax liability.

With a continuous function for tax avoidance, you keep going until you disvalue at exactly $1 the cost of avoiding another $1 in taxes.  Let’s call that the satiation point.
Suppose there is just 1 tax instrument with a 40 percent rate on whatever it might be (wages, Haig-Simons income, consumer spending, wealth, etc.).  Any time you lower the tax base by $1, you save 40 cents of tax.  So you reach the satiation point when it costs you 40 cents (in utility terms) to get a dollar out of the tax base.

Now suppose instead there are 2 tax instruments, each with a 20 percent rate.  Multi-instrument avoidance reduces them both, so the government’s shift to two distinct tax instruments has no effect.  But suppose some avoidance techniques work on only one of the two systems.  For example, a loss-creating tax shelter works against the actual income tax, but not against a typical VAT.  Then you reach the satiation point at 20 cents, instead of 40.

Where only single-instrument avoidance is feasible, multiple tax instruments turn tax avoidance into a costly retail exercise, rather than a cheap wholesale exercise.  The result, less tax avoidance, is unambiguously good within the paper’s assumptions.  What is more, absent an offsetting concern about tax overhead costs, there would be no obvious limit to how many separate systems this analysis suggests that we should have. 

In my view, this analysis logically holds together.  However, the paper’s interpretation of it as suggesting more specifically that we should use all of a labor income tax, VAT, capital income tax, wealth tax, etc., puts me in mind of the following three issues:

(1) Information versus evidence – Note two distinguishable types of issues in tax system design.  First, what is relevant information that should affect tax liability? Second, how as a technological matter do we get at that information?  What evidence can we use to measure it?

By information, I mean something that we want to affect tax liability.  Examples might include labor income and, more controversially, returns to saving.  By evidence, I mean something that we use to get at the underlying information. 

David cites a paper by Roger Gordon and Soren Nielson that considers a VAT and cash-flow income tax that are assumed to have identical behavioral and distributional consequences when accurately applied, but involving different means of avoidance.  You avoid the VAT through cross-border shopping.  You avoid the consumed income tax by concealing receipts.  As is well-known in the tax policy literature, either receipts (sources of income) or consumer spending (uses of income) can be employed towards measuring consumption.  Gordon and Nielson show that it’s plausible one would want to use some of each instrument, so that taxpayers can’t avoid the entire tax along either tax planning dimension.

In this model, the VAT and the consumed income tax both seek to rely on the same information (i.e. how much was consumed), but use different evidence.  By contrast, a realization-based income tax, a VAT, and an estate & gift tax (to name three well-known types of tax system) differ in the information that they treat as relevant, not just in the evidence they use.  The VAT bases liability on consumption, the income tax aims to reach work plus saving, and the estate and gift tax aims at the making of gratuitous transfers (which implies underlying work and saving).

In theory, there is a right answer as to the extent to which tax liability should depend on these different types of information.  That right answer ought to be implemented as to the overall tax system, without regard to separate instruments.  (And yes, I recognize that the relevant information might be viewed merely as evidence of something else still, such as ability or opportunity or expected marginal utility of a dollar).

The mark-to-market income tax, VAT, and estate & gift tax may also, quite distinctly, use different types of evidence that invite different avoidance mechanisms.  For example, the realization-based income tax encourages strategic trading (hold the winners, sell the losers).  For the VAT, there’s unreported cross-border shopping.  The estate and gift tax obviously has a slew of avoidance techniques of its own, but also permits the tax authority to take a one-time in-depth view of everything that the taxpayer has on hand at death.

Suppose you like the different evidence but not the different information.  For example, you might like taxing estates as a backup to the income tax (both for fraud problems and the holding of appreciated assets).  But that would imply a different design for the estate tax than if you actually want tax liability to depend on bequests as an end in itself.

One last point about information: the existing income tax deliberately uses some types of information other than about income.  Examples include the itemized deductions for home mortgage interest and charitable contributions, along with the exclusion for employer-provided health insurance.  While the paper groups these items with other tax avoidance, they are in fact meant by the policymakers to affect tax liability.  In principle, if allowing them is the right policy, we would want to hold constant when using multiple instruments.

The paper notes that, in practice, such items may often be bad policy, and that the predilection to use particular ones seems oddly instrument-specific.  For example, VATs but not income taxes commonly offer reduced tax rates for food.

Is using more instruments likely to increase or reduce the political tendency to make bad choices regarding the use of information to affect tax liability?  The answer to this question is certainly far from clear.

(2) What is an instrument? – The paper defines “tax instruments” as any policy variable that a government might adjust to raise revenue or affect distribution.  Sometimes, however, “instrument” seems to connote instead formally distinct systems.  But you can have multiple instruments in the same system.  An example would be diversifying income tax audit selection techniques to reflect, say, both omissions suggested by counter-party reporting and “lifestyle audits” of people who appear to be doing quite well but haven’t reported commensurate income.

(3) What is tax avoidance? – Taxpayers may want to reduce reported tax liability whether doing so leads to a better or worse measure of the true underlying information.  Consider, for example, documenting legitimate business expenses, or making sure that losses will be deductible, notwithstanding the capital loss limitation, in instances where they truly are representative of overall economic results (i.e., one doesn’t have offsetting unrealized gains).  In principle, while taxpayers’ incentive to reduce tax liability may be too “strong” from a social standpoint (Louis Kaplow has an article on this), the socially optimal incentive is greater than zero.  The paper’s analysis of tax avoidance is premised on its being “incorrect” (not necessarily legally, but in relation to underlying information that is of distributional interest), and the correctness issue makes this more complicated, raising once again the issue of what information we consider relevant.

NYU Tax Policy Colloquium, week 13, David Gamage's "A Framework for Analyzing the Optimal Choice of Tax Instruments," Part 1

Yesterday at the NYU Tax Policy Colloquium, David Gamage presented the above paper.  The following discussion is adapted from my notes for the session.  Part 1 is in this blog post, and I’ll put Part 2 in the next one.

The paper responds to the “double distortion” literature in legal tax scholarship which draws the conclusion that distributional objectives should be pursued entirely through a progressive consumption tax (leaving aside the use of transfers to address the lower end).  Under this view, there should be no other distributional instruments in the tax system (e.g., no income tax, inheritance tax, or luxury taxes), and no use of legal rules to address distributional objectives.

The paper, by contrast, argues for using lots of smaller separate systems to address distribution.  For example, it suggests that we might want to use of all a labor income tax, a VAT, a capital income tax, a wealth tax, and legal rules to address distribution.

We’ll discuss (1) the double distortion literature, and (2) the paper’s argument for using multiple tax instruments to address distribution.  [But this post only includes Part 1.]


This is a legal literature based on certain economics literature.  Economists may be bemused by how this legal literature treats this economics literature.

The double distortion literature’s central point is simply to rebut a particular fallacy.  Suppose we are discussing the choice between an “ideal consumption tax” and an “ideal income tax.”   The consumption tax just distorts one decisional margin: labor supply.  The income tax distorts two margins: labor supply and saving.

So far, so good.  But the fallacy involves positing that, by also distorting savings decisions, the income tax inherently does less to distort labor supply decisions.  To illustrate, suppose we are making a revenue-neutral choice between a 25 percent consumption tax and a 20 percent income tax.  (The income tax raises the same revenue with a lower rate because its base is “broader.”)  Seemingly, labor supply is less discouraged by the income tax because the tax rate is lower.

This analysis fails, however, if one accepts that a worker who may save is funding present consumption plus future consumption through his current labor supply.  Suppose that I will spend some of my labor income this year and some in the future.  Whereas the 25 percent consumption tax imposes a 25 percent excise tax on all consumer goods that I might choose, the income tax, by reason of its hitting intermediate saving, in effect imposes a higher excise tax on future consumption goods than current ones.  Suppose the effect of the income tax on my deferred consumption is the equivalent of hitting it with a 30 percent excise tax.  We don’t inherently reduce labor supply distortions by converting the uniform 25 percent excise tax on consumption into the equivalent of a 20 percent excise tax on some consumption and a 30 percent excise tax on other consumption.

To a first approximation, therefore, the income tax merely layers the savings distortion on top of the labor supply distortion, rather than imposing it partly in lieu of that distortion.  This means that taxing saving would require some motivation other than the mistaken idea that it inherently permits one to reduce labor supply distortions.

The famous Atkinson-Stiglitz (1976) article on which the double distortion literature draws also rules out (by express hypothesis) one further possible argument for the income tax.  It assumes separability between labor and all consumer goods, so that how much you work in the current period does not affect (among other things) your preferences between current and future consumption.  If separability did not hold, and saving for future consumption turned out to be a leisure complement while higher current consumption was a leisure substitute, then one might actually offset some of the labor supply distortion by taxing future consumption at a relatively high rate (as the income tax does, although there’s no reason to think it would supply the optimal rate differentiation). But even if we question separability, for all we know the relationship between current and future consumption on the one hand and labor supply on the other might lie in the opposite direction.  Separability is arguably a reasonable presumption from ignorance, at least until we have some question not to question it but to think that it errs in a particular discernible direction.

What about other possible motivations for taxing saving?  They simply aren’t in the Atkinson-Stiglitz model.  And there is no reason why they should be.  A given model can only reasonably do so much.  But possible motivations for taxing saving might include at least the following:

 (1) Suppose that saving is a tag of high ability.  Then we might want to tax it for the same reason that one taxes earnings (and might decide to tax, say, height) in an optimal tax model.

(2) Suppose we believe that people make many consumption decisions on a per-period basis, rather than a lifetime basis. Then current resources (i.e., savings) may have distinctive current-period distributional relevance.

(3) Savings offer a cushion to hide one’s ability by working less.  They therefore undermine the use of an earnings tax to provide ability insurance, supporting an argument that they should be taxed.

(4) Suppose that, especially after having read Piketty’s Capital in the Twenty-First Century, we believe that saving plus inheritance leads to accelerating inequality that has serious adverse consequences.  Then one could view saving (or at least inheritance) as having significant negative externalities, like pollution.  This provides a reason to tax saving (or at least inheritance) if we believe that these adverse consequences outweigh any positive externalities from saving.

(5) Suppose we believe that income taxes will generally be more progressive in practice than consumption taxes, for reasons of political economy.  If one wants the tax system to be more progressive within the relevant range, this may motivate supporting income taxation even if it is otherwise inferior.

Now, all these may be either good arguments or bad ones.  The point of interest in relation to the “double distortion” literature is simply that it provides absolutely no ground for evaluating them – nor should it; that isn’t its “job,” which is simply to address the fallacy described above.  Lawyers who think that Atkinson-Stiglitz 1976 is relevant to any of these questions are mistaken – as I rather suspect Atkinson and Stiglitz themselves would agree.

(Random digression, reflecting that Atkinson and Stiglitz can speak for themselves on this point, if they are so minded: Recently I mentioned to a class that the author of a particular article might disagree with how his argument was being interpreted.  This reminded me of the scene in Woody Allen’s Annie Hall where Woody refutes a loudmouth on a movie line who is purporting to explicate Marshall McLuhan, by bringing out McLuhan himself, who happens to be in the lobby.   I discovered that almost none of the students had seen Annie Hall.  A canonical cultural reference 20 or more years ago – as, say, The Godfather still is – Annie Hall apparently has lost that status.)

Anyway, back to the double distortion literature.  The Kaplow-Shavell stricture against using legal rules to address distribution addresses the same fallacy.  To give this point contemporary policy relevance, suppose that we are concerned about the effect of CEO compensation and financial sector returns on high-end inequality.  Now, we might have independent regulatory reasons for addressing CEO pay and financial sector returns.  For the former, perhaps their pay often vastly exceeds the marginal private value of their production because of agency costs, collusive boards, etc.  For the latter, perhaps financial sector returns often vastly exceed marginal social value because they reflect front-running, duping customers through complexity and opacity, etcetera.

If these critiques are correct (and I certainly find them generally plausible), then we have straight efficiency reasons for addressing CEO pay and financial sector returns.  But the Kaplow-Shavell double distortion / don’t use legal rules for distribution line of argument would say: We shouldn’t over-correct, and make CEO pay and financial sector returns too low, rather than too high, in response to the distributional effects, even if we strongly dislike those effects.  Rather, we should address the distributional issue purely through the tax system (i.e., with a progressive consumption tax) so that we don’t create labor supply distortions PLUS (and by no means instead of) particular distortions in these markets.

Once again, the double distortion argument addresses a particular fallacy, which is that we can inherently avoid labor supply effects by targeting narrower areas of high-wage labor.  But it does not address other possible arguments for using legal rules in these two contexts, if (as in the case of the above-noted arguments for taxing savings) plausible rationales of some entirely different kind are offered.

Teaser for my next post, where I will turn to the particular main arguments in the Gamage paper: Suppose that over-addressing CEO pay and financial sector returns through targeted regulation has the advantage of eliminating the use of tax avoidance techniques that would inevitably hamper using the distribution system.  In particular, even with a shift from the current income tax to a progressive consumption tax, suppose that we couldn’t eliminate particular “tax gaming” tricks that would allow CEOs and financial players to wipe out the intended tax liability.  Then, even if they also separate have bags of tricks to deploy against the regulatory regimes, we might want to use the regulatory system after all to do some of the distributionally-minded work.  This would merely involve trading off the reduction in opportunities for tax gaming against the increase in sectoral inefficiency and regulatory gaming.  But arguably the optimal extent to which we would use the regulatory system, by reason of this tradeoff, is greater than zero.

Closing comment on the double distortion literature: I’d analogize the usefulness of Atkinson-Stiglitz (“AS”) in the public economics literature to that of Modigliani-Miller (“M-M”) in the finance literature, with a twist.  MM shows that the choice between debt and equity is irrelevant to firm value unless there are tax issues, bankruptcy issues, other relevant regulatory regimes that treat the two differently, or agency cost / asymmetric information issues.  MM doesn’t show that debt-equity choices ARE irrelevant, given that those issues may exist.  Rather, it shows where we would have to look in order for such choices to matter.

Likewise, AS doesn’t show that we should only use a (potentially progressive) consumption tax to address all distribution issues.  Rather, it shows us where NOT to look for an argument in favor of using something else.  That clears the decks so that the analysis can move on to the questions of real interest that remain.

Monday, April 28, 2014

My remarks at the NYU event on my international tax book

As I mentioned in an earlier post, today was the date for an event at NYU Law School concerning my recently published book on international taxation.  I was very pleased that Martin Sullivan and Itai Grinberg both came down from Washington to discuss the book, and that a good-sized audience (as such things go) attended the session even though exams are pending for students.

I won't try to summarize what Marty and Itai had to say, although frankly I'd be glad if their comments got wider distribution.  (And not just because all publicity is good publicity.)  But here is a written version of my remarks at the session, putting the book in context and offering a quick overview:

This book is in some ways a sequel to an earlier book that I wrote, called Decoding the U.S. Corporate Tax.  Now, of course you know the iron law of movie sequels.  With just one exception, they’re never as good as the original.

The exception isn’t The Godfather, Part 2, which is too slow-moving and self-important.  It’s Gremlins 2, which was better than the original for a reason.  It was more of a horror-comedy than the original Gremlins.

Fixing U.S. International Taxation isn’t comedy – for that, you’d have to try my novel, Getting It.  But it does do one thing that’s different from its precursor.

Decoding mainly just summarizes the existing economics literature on corporate taxation, trying to make it more accessible.  I got frustrated when I couldn’t find suitable accounts of the literature for my tax policy classes.  Plus, I figured that, if I wrote the guide myself, I’d probably agree with most of it, even a couple of years later.

With Fixing, I initially wanted to do much the same thing for international tax.  But there was a problem.   I had to adjust for what I considered the sorry state of the literature.  As I say in the book, despite more than 50 years of analysis by really good people, at some point it went badly off the rails.

I’m not alone in thinking this.  For example, Michael Graetz gave a Tillinghast Lecture here some years back entitled “Taxing International Income: Inadequate Principles, Outdated Concepts, and Unsatisfactory Policies.”

So I concluded that I needed to reinvent the wheel a bit, albeit using familiar public economics ideas.  And not to be grandiose, many others have been moving in the same direction as I have.  But there was certainly nothing out there putting it all together in a way that I considered suitable.

Let me start with a simple illustration of the underlying problem.  Say the U.S. corporate tax rate is 35%, while Germany’s is whatever.   So the U.S. taxes all corporate income that’s earned here at 35% , whether it’s earned by a U.S. company, a German company, or anyone else.

If we want, we can also tax U.S. firms’ German income at 35%, or indeed at any other rate we like.  But we simply can’t impose any tax on the German income of German firms – or on any other foreign source income of non-U.S. firms.

If only we could tax foreign companies’ foreign source income, that would actually be great for us.  Foreigners who owned those companies would in effect be making large tax payments to the U.S. Treasury, which we would get to spend as we liked.   And no one would be able to avoid the source-based U.S. tax by investing outside the U.S., rather than here.

But even Dick Cheney, or Vladimir Putin if he were American, would know better than to try taxing foreign firms’ foreign source income.  So we face a constraint.  There‘s a 2-by-2 grid yielding 4 boxes – the U.S. and foreign source income of U.S. and foreign firms.  But the income in one of the boxes we simply can’t tax.

This brings us to one of the key points at which the international tax literature went off the rails.  In tax policy thinking, we tend to like neutrality, because, while taxes are a private cost to the taxpayer, they aren’t a social cost. Rather, they’re a transfer from one person to others.  If you have two or more choices and the tax system treats them neutrally, it can keep the choices’ relative payoffs in the same order, so it doesn’t induce inefficient behavioral changes that reflect treating taxes as a cost rather than a transfer.

But given the four boxes and the one we can’t reach, there are two different ways we could be neutral here between adjacent boxes: by equalizing U.S. versus foreign investment by U.S. firms, or U.S. versus foreign firms making foreign investments.  We can’t be neutral at both margins.

A big mistake has been to assume we should pick one or the other neutrality, and push it all the way while ignoring the other margin.  That’s generally not good thinking.  When you can avoid making all-or-nothing choices, why wouldn’t you?  Chocolate brownies or cheesecake?  I think I’ll have a little of each.

For more of a formal economics example, say there are just 3 drinks – milk, juice, and water – and that we want to tax them in connection with raising revenue as efficiently as possible.  Suppose that we simply can’t tax water, and that we’re taxing milk at a high rate, because it’s not very price-elastic – the people who like it will mainly keep on drinking it.  Finally, suppose that if we raise the price of juice by taxing it, people will switch into water relatively fast.  There’s actually a literature, called optimal commodity taxation or Ramsey pricing, which shows that we shouldn’t choose between milk-juice neutrality, by taxing juice at the milk rate, and water-juice neutrality, by not taxing juice at all.  Instead, if we want to raise revenue as efficiently as possible, we should tax juice at an intermediate rate, somewhere between that for the other 2 commodities.

In terms of international tax policy, U.S. source income is milk, foreign firms’ foreign source income is water, and U.S. firms’ foreign source income is juice.  We have more market power over investing in the U.S. than over using U.S. firms to invest abroad.  Perhaps this helps explain why almost everyone agrees that we shouldn’t actually tax U.S. companies’ foreign source income at the U.S. effective rate.  It also helps to show the likely undesirability of setting the U.S. tax rate for U.S. firms’ foreign source income as low as zero.

Let me turn to another big piece of the puzzle which I have ignored so far.  When U.S. and German firms earn income in Germany, presumably they will face German taxes.  How should we think about that, from a U.S. standpoint?  Unfortunately, this is a second place in which the international tax policy literature has gone off the rails.

Suppose the U.S. and Germany both tax U.S. firms’ German source income at 35% (although Germany’s actual corporate rate is lower).  And suppose both countries likewise tax the U.S. source income of German firms.  Even with foreign taxes being deductible in the residence countries, cross-border investment would face a combined tax rate of almost 60%.  Wouldn’t that unduly discourage it, probably to the detriment of people in both countries?

The answer is yes.  But the literature made 2 main mistakes in analyzing this concern.  First, it defined the problem as double taxation of cross-border investment, rather than as overly high taxation.  Focusing  on the number of taxes levied, rather than on the overall tax burden imposed, is unhelpful.  Personally, I would rather be taxed twenty times at a 1% rate each time, than once at 50%.

Second, the analysis assumed too quickly that, in deciding what to do about the problem, U.S. and German taxes should automatically be viewed as equivalent.  From a U.S. standpoint, they are not equivalent.  We get the money from our own taxes, but not from theirs.  And of course the Germans should think the same way from their perspective.

Now, there may be room for the U.S. and Germany to cooperate by reciprocally deferring to some of each other’s tax claims, to mutual advantage.  But you have to actually look at the strategic interactions, not just assume that German and U.S. taxes are the same from a U.S. standpoint.   And in fact today we provide a foreign tax credit for German taxes, but they don’t reciprocate.  Instead, they generally exempt German companies’ U.S. income.  This equally avoids “double taxation,” but it means that German firms in the U.S. will always want to minimize their U.S. taxes, whereas U.S. firms in Germany won’t care about their German taxes if they anticipate claiming immediate U.S. foreign tax credits.

This brings me to the broader problem of how the literature has analyzed the choices that a country has when deciding how to tax resident companies’ foreign source income.  Supposedly, there are just 2 respectable options: exempting foreign source income, or having a worldwide system with foreign tax credits.

The problem, from the standpoint of clear thinking, is that these are compound choices.  They differ at two margins, not just one.

First, exemption taxes U.S. companies’ foreign source income at a zero rate, while worldwide uses the full domestic statutory rate.  Apparently, intermediate statutory rates for foreign source income are verboten.

Second, the two systems differ in their marginal reimbursement rates, or MRRs, for foreign taxes paid.  Exemption has a zero MRR – paying foreign taxes has no effect on your U.S. tax liability.  However, since this matches the approach’s zero marginal tax rate for foreign source income, exemption is what I call an implicit deductibility system for foreign taxes.  Under exemption, U.S. taxpayers want to maximize their after-foreign-tax foreign source income, just as they would with foreign tax deductibility and any positive U.S. tax rate below 100%.

What about a typical worldwide system?  In principle, foreign tax credits create a 100 percent MRR for foreign taxes paid on foreign source income.  You get every penny back, barring the application of foreign tax credit limits.  If this were the entire story, U.S. companies would generally be indifferent to whether the foreign taxes they paid were low or high.

As it happens, in practice U.S. companies are usually anything but indifferent to their foreign taxes.  They want to minimize those taxes, just like our taxes, and they are very good at doing it.  This reflects the real world consequences of another important U.S. international tax rule, called deferral, under which you don’t have to pay U.S. taxes on your foreign subsidiaries’ earnings until you’ve officially brought the money home, which you may never actually need to do.

In Fixing, I analyze how deferral and foreign tax credits interact to affect U.S. taxpayers’ incentives.  In short, each rule has bad incentive effects when considered in isolation, but somewhat reduces the other’s bad effects.

Deferral encourages costly tax planning maneuvers, in lieu of just using internal funds efficiently.  But if you have enough foreign tax credits, you can bring your foreign earnings home tax-free.  So foreign tax credits can reduce deferral’s undesirable incentive effects.

On the other side of the ledger, consider again the effect of foreign tax credits in reducing cost-consciousness with respect to foreign taxes.  If you anticipate either permanent deferral or a future reduction in the tax rate on repatriations, you may be highly foreign tax cost-conscious after all.

Still, a system with both rules is guaranteed to have high tax planning costs and other deadweight loss relative to the revenue actually raised.  So having both deferral and foreign tax credits, as we do today, is definitely not a good answer.

The interaction between these two bad rules puts us in what I call an “iron box.”  Scale back deferral and you worsen the problems caused by the foreign tax credit.  Scale back foreign tax credits and you worsen deferral.  Change either or both of them and you alter the overall effective U.S. tax rate on foreign source income – the merits of which have nothing to do with deferral and foreign tax credits in particular.

Let me just mention two more themes from the book.  First, on a more theoretical note, I spend a lot of time devising what I’d like to hope were final burial rites for a set of concepts that have played much too large a role in international tax policy debate.  These are single-bullet global or national welfare norms such as capital export neutrality, capital import neutrality, capital ownership neutrality, national neutrality, and national ownership neutrality.  Each of these concepts has an acronym, such as CEN or CIN, so I deride using any of them as the “battle of the acronyms” or “alphabet soup.”  Lawyers have tended to over-use these terms more than economists, but plenty in both groups have come to realize that they don’t help much.  I just try to summarize and spell out a case against them that was already well-known in the best circles.

Second, the international tax issue that has rightly gotten the largest headlines in recent years is rampant base erosion and profit-shifting by numerous well-known companies.  This reflects the tax planning opportunities that the companies have in the present environment, what with high global capital mobility and the huge economic role of intangibles.  I don’t have as much that’s new to say about these problems as I do about the basic structural elements of our international tax system, which is why I don’t emphasize them more.  But two points about them that I do make in Fixing are the following.

First, it’s well-known that we can’t actually get the source rules right, because source is not a well-defined economic idea.  But we can try to make it costlier for multinationals, in a business and planning sense, to treat so much of their income as arising in tax havens.  This is exactly how economic substance rules limit aggressive tax sheltering – for example, by requiring undesired downside economic risk as the price for successfully claiming huge artificial losses.  In the international tax realm, this approach is likely to require paying far less heed than we currently do to the formal legal lines between commonly owned entities.

Second, all else equal, it’s actually a good thing, from the U.S. standpoint, if a U.S. company pays less foreign taxes, rather than more.  Again, the foreign taxes are just a cost from our standpoint, because we don’t get the money.  But the complicating problem, which helps to explain why exemption countries have anti-tax haven rules, is that, when we see significant income being attributed to a haven, and we know that it couldn’t actually have been earned there, we have reason to suspect that we, and not just foreign governments, may be among the losers.  In effect, income’s being reported in a tax haven is a tag that indicates its potentially suspect status from the standpoint of protecting our domestic tax base.

A reasonable response to this concern may involve treating the foreign taxes that our companies pay as effectively better than just deductible, but worse than fully creditable.  The Baucus international tax reform plan in Washington actually takes a stab at doing this, in an apparently treaty-compliant way.

There’s a lot more I could say – the book is about 200 pages long, after all – but instead why don’t I stop here, and listen with interest to what Marty and Itai have to say.

Thursday, April 24, 2014

I weigh in on one of the great issues of the day

See the news article here on a current legal controversy under the New York State sales tax.

It is probably fair to say that, while as quoted in the article it sounds as if I consider the legal issues closely balanced, in fact I would need very heavy odds to consider betting on the taxpayer.  Although I'm not a constitutional specialist, the argument for the state that I describe certainly sounds hard to challenge.  In addition, the question of fact under the applicable statute - whether "presentational dance entertainment" of a certain type should count as a "dramatic event" for purposes of a state sales tax exemption - was the subject of prior fact-finding by an administrative judge.  Hence, unless demonstrably unreasonable I would assume that it is likely to withstand further judicial review.

The reporter didn't use my joke, which was that it's a sad day when the taxpayer here (read the article to see who it is) couldn't get a state auditor named Saint-Amour to evaluate in person whether its "presentational dance entertainments" were indeed "dramatic events."

NYU Tax Policy Colloquium, week 12: Kim Clausing's "Lessons for International Tax Reform from the U.S. State Experience Under Formulary Apportionment"

This past Tuesday, Kim Clausing presented the above paper.  It examines evidence concerning the U.S. states' experience with formulary apportionment for corporate income.

The background is as follows.  With the source of income being notoriously difficult to pin down, when earned by a multi-jurisdictional company, two main approaches currently prevail.  In the international realm, countries generally use transfer pricing.  For example, in deciding to what extent Apple's worldwide income pertains, say, to the U.S. parent as opposed to an Irish affiliate (and is treated as U.S. source as opposed to foreign source), the key question is what arm's length price we should attribute to the hypothetical transaction between the two affiliates.  By contrast, when the same issue rises within the U.S. under state and local income tax systems, various formulary apportionment (FA) approaches apply.  Under classic FA, the percentage of the national company's income that is treated as arising in-state depends on the extent to which the company's property, payroll, and sales are to be found in-state rather than out-of-state.  (Intangible property usually is kept out of the property computation, given the difficulty of assigning it a meaningful location.)

Charles McLure famously showed, in an article some decades ago, that state and local corporate income taxes, when the taxable share depends on FA, resemble directly taxing the apportionment factors.  Thus, basing the income measure is a bit like having a property tax - if you locate more property in the state, you owe more, although the details also depend on the amount of overall corporate income.  Likewise, using the payroll factor is a bit like taxing in-state employment, and using the sales factor is a bit like having a sales tax.

Recent decades have brought considerable movement at the state level away from using a simple three-factor formula in which all three of the above get equal weight.  For example, a number of states double-weight sales, and others only look at sales.  This shift reflects pressures of tax competition, and/or arguments made to state legislators based on tax competition, with the idea being that you don't want to lose in-state investment or job opportunities, but that sales are relatively immobile.  It also has the effect, albeit crudely and imperfectly, of making states' corporate taxes more destination-based, and possibly also more sales tax-like.

A study of the economic effects of using FA, with or without giving sales pride of place, is of interest given the possibility that a given country, such as the U.S., could revise its international rules to move part or all of the way from transfer pricing to FA.  (The U.S. rules already have some formulary elements, however - for example, pertaining to interest expense - and it's also likely true that in practice putting more factors in a given jurisdiction may influence transfer pricing outcomes.)  Indeed, Clausing has coauthored an article, with Reuven Avi-Yonah and Michael Durst, arguing for the use of sales-based FA in international taxation.

A couple of earlier papers in the field found that states did indeed get some of the positive effects they were seeking (for example, with respect to employment) when they shifted towards giving sales greater weight in the formulas.  Clausing's study, however, finds very little effect apart from revenue loss (which apparently was anticipated).  The why of the revenue loss is itself an interesting question, possibly reflecting who converted when and also the fact that lots of sales escape being allocated anywhere under typical state formulas.

The paper's somewhat negative finding arguably suggests that shifting to FA in international tax would prompt only smaller, rather than larger, real tax planning responses.  On the other hand, as it recognizes, extrapolating from the state to the international level can be risky.  State and local tax rates may be too low to induce much tax planning, especially if it has significant fixed costs, but this clearly need not be true at the international level.  On the other hand, it's presumably easier to shift factors such as property and payroll between states in the U.S., as distinct from between separate countries.

Also, if the paper's finding smaller responses than the earlier literature had reflects a change over time, as more and more states altered their formulas, this might be evidence of early mover advantages.  That might weigh in favor of a given country's deciding to be the first or one of the first to shift from transfer pricing to FA.

I think of the case for FA as based largely on "costly electivity" - that is, on the hope that forcing companies to make real changes in what they do, as the price of getting more favorable results, will have a favorable ratio of revenue raised to deadweight loss incurred. Whether this hope would be realized in practice would depend in good part on the design of the FA rules, and in particular how they countered various new tax planning opportunities that they might create in lieu of the old ones.

In two weeks, we will return to transfer pricing versus FA as an international tax issue, in connection with a paper by my NYU colleague Mitchell Kane that reflects greater sympathy for transfer pricing in the international realm than I personally can summon up, based in good part on claimed advantages from its being already in place.  I've been working ahead as the end of the semester nears, but will wait to address here until that session actually occurs.

Thursday, April 17, 2014

NYU Tax Policy Colloquium, week 11: Nirupama Rao's "The Price of Liquor Is Too Damn High: State-Facilitated Collusion and the Implications for Taxes"

On Tuesday, we discussed the above paper, which was our second (the first being Saul Levmore, week 1) to discuss the choice and interplay between "tax" and "regulatory" instruments.  The paper concerns the measures states take to limit or control alcohol consumption, often with evident secondary (or should I say primary) aims of empowering cartels and favoring local over out-of-state producers.

Alcohol clearly is a good subject for Pigovian taxation.  Drunk driving accidents are certainly the clearest example of negative externalities resulting from alcohol consumption, but not necessarily exclusive.  One could also make internalities arguments, especially with regard to young drinkers.

As a theoretical matter, Pigovian taxes are easier to design in some cases, harder in others.  An article called "Taxation and the Financial Sector," which I coauthored with Douglas Shackelford and Joel Slemrod, makes the point that the negative externalities imposed by financial firms when they risk failure that may lead to bailout and/or horrendous macroeconomic consequences, are very context-specific and hard to capture accurately in a tax instrument.  One institution compared to another, or one state of the world compared to the other, may make all the difference in determining what the tax level ought to be.  On the other hand, for carbon taxation that is aimed at global warming, while the overall harm measure may be difficult to nail down, at least we know that all carbon molecules are relevantly the same.

Alcohol arguably is somewhere in the middle.  On the one hand, it's true that each unit of wine, beer, or spirits has a determinate amount of alcohol in it.  But even sticking to the externalities, it matters who is drinking, as well as how much that person is drinking at the same time.  One could imagine a sci fi dystopia in which everyone is equipped with monitors for alcohol in the blood that permits the imposition of personalized Pigovian taxes.  But since, in the real world, purchase not consumption of liquor is the occasion for levying the tax, we can't come close to doing that.  Thus, moderate drinking that may improve one's physical and mental state is hard to except from the regime that is aimed at drunk drivers and self-destructive alcoholics.

There are some fallback methods available.  For example, we (try to) ban under-age drinking.  And differential taxes on wine versus beer versus spirits can proxy for the things we'd like to measure directly.  For example, if we think that young drinkers tend both to prefer beer and to impose the highest drunk driving externalities, we might for that reason subject beer to a higher tax relative to alcohol content.  Not surprisingly, however, the states turn out to view things a bit more parochially.  California, with its big wine industry, is very nice to wine.  Pennsylvania, with its blue collar tradition that we hear about ad nauseum in every presidential election year, is nice to beer.

Explicit excise taxes on alcohol are mainly federal, and only secondarily (by dollar value) state and local-level, and most experts would probably say that, on balance, and despite the variability that we can't capture very accurately, they are set too low, rather than just right or too high.  Arguably this reflects the cultural difference in today's world between alcohol and, say, cigarettes.  I would speculate that "sin" taxes which are best rationalized on externalities grounds are highest when the sin is one that "we" don't indulge in - only "they" do.  By "we" I mean representative voters, with "they" being the Other in such voters' eyes.

Evidently, in the era that led to Prohibition, to some extent there was a view that only "they" drink - "we" don't.  Then if you go the Mad Men era, evidently "we" both drink and smoke.  Today, however, smoking is declasse while drinking is not.  So "they" smoke and let's tax it a lot, but "we" drink so let's not tax it so much.

OK, onto the state regulatory structures that the paper discusses.  The front part of its title, "The Price of Liquor is Too Damn High," might more accurately be stated as "The Pre-Tax Price of Liquor is Too Damn High, Albeit That the After-Tax Price Might Conceivably Be Too Low."  States do a number of cartelizing things in the market for alcohol sales that end up raising the price.  These measures may have Pigovian benefits if they suitably reduce alcohol consumption, and they apparently do reduce it.  But doing this through the creation of market inefficiencies means that the Pigovian revenues are either lost in pure waste or handed off to wholesalers who are aided by the state regulators in realizing monopoly profits.

A case in point, and the paper's main focus, is Pennsylvania's "post and hold" regime with lookback.  Here's how it works.  Pennsylvania has a lot of rules in the alcohol market that at least ostensibly are aimed at protecting small retailers, in particular against the likes of Costco.  (In an unregulated market, Costco would likely be able to get a better wholesale price, reflecting either cost-saving from the scale that it offers and/or its exercising monopsony power.)

To this end, Pennsylvania requires wholesalers to state in advance the uniform wholesale price that they will charge to all retailers for one month after the posting.  That is "post and hold."  It facilitates collusion in pricing between wholesalers, and apparently helps result in Pennsylvania's having significantly higher liquor prices than Massachusetts, an adjoining state without post and hold rules.

"Lookback" is the crown jewel of post and hold, so far as permitting wholesalers to reap cartel profits is concerned.  Under lookback, once you have posted your price for the month, you can lower it to match a competitor's posted price.  This makes it really attractive to aim high on your Stage 1 price, knowing that if someone undercuts you it won't be a problem, and that, for the same reason, you can't undercut them.  Especially with repeat players and monthly posting, this is simply a great device from the standpoint of wholesalers who want to collude in ways that would land them in jail for antitrust violations (or else make sufficient cooperation between would-be cartelizers unstable), but for the state's facilitating role.

Anyway, if the alcohol price would otherwise be too low from a Pigovian-plus-internalities standpoint, higher prices from post and hold plus lookback at least have the virtue of reducing alcohol consumption, conceivably closer to its optimal level.  But it's equivalent to the state's converting the Pigovian tax revenues into a combination of handouts to liquor wholesalers plus dissipation through waste.  The paper makes this case, in addition to showing (both theoretically and empirically) how post and hold plus lookback operate to raise retail prices for alcohol.

Wednesday, April 16, 2014

My article on Henry Simons has finally been published

My article on Henry Simons, which I presented at a Florida State University Law Review symposium a bit over a year ago, has finally officially appeared in print.  You can find it here.

The abstract goes something like this: "Surely just about everyone in the U.S. federal income tax field has heard of Henry Simons, if only for his famous definition of “personal income.”  Few may realize, however, that this proponent of 'drastic progression' in a broad-based income tax was also a self-described libertarian who generally denounced government economic regulation and was arguably the chief architect of the pro-free market law and economics movement at the University of Chicago.  This article provides a brief intellectual history of Simons’ work, aiming in particular to explain how and why he combined these seemingly disparate sets of beliefs, and what we may learn from them today."

I must confess I rather like, and enjoyed writing, this article, although it is not quite history and also, as a friend who prefers some of my other work told me, is not as "analytical" as I sometimes might be.  This reflects that it's partly a literary enterprise and character study.  

Tuesday, April 15, 2014

NYU book event regarding my international tax book

I'm very much looking forward to the following event, more fully described here.

"Fixing U.S. International Taxation by Daniel Shaviro – Monday, April 28th, 12:30 PM to 1:50 PM – Vanderbilt Hall Room 220, 40 Washington Square South:

"Please join us for a discussion of Professor Daniel Shaviro’s current book, Fixing U.S. International Taxation (Oxford University Press, 2014). 

"Following a presentation by Professor Shaviro of key themes from the book, leading experts in the field will offer commentary.  We are thrilled that Martin Sullivan, Chief Economist at Tax Analysts (publisher of Tax Notes), and Professor Itai Grinberg, Georgetown University Law Center, will join us.  We will also save time for a question-and-answer session with the audience."

At the event, the NYU Bookstore will be offering copies of the book for sale at a 20% discount.  I suppose inscriptions aren't out of the question either, should any demand for them materialize.

Later the same day, Sullivan will also be giving a talk on a topic of general interest to our audience, most likely pertaining to recent developments in the tax reform process.  I will post that here when it's up officially.

UPDATE: Sullivan's 6 pm talk at NYU Law School on Monday, April 28, will have the title: "Tax Reform 2017: Incremental or Fundamental?"

NYU Tax Policy Colloquium, week 10: Susannah Tahk's "The Tax War on Poverty"

Last Tuesday (April 8), Susannah Tahk of the University of Wisconsin Law School presented the above-named paper.  As noted in an earlier post, I was forced by external circumstances to fall short of my usual practice of promptly posting here a discussion of the issues that the paper raises.  But better late than never.

The paper documents and evaluates the rising use of tax provisions to do heavy lifting with respect to programs that are aimed at aiding the poor.  The most important example is the rise of the EITC, including its refundable element, and the relative decline of direct cash grants under TANF today as compared to AFDC twenty years ago.  There is also the fact that, say, the child tax credit, while aimed in large part at the “middle class,” is partly refundable, to the benefit of poor households with children.

It’s clear that use of the income tax system in lieu of direct transfers to pay money to poor people has potential optical advantages, compared to overtly using the transfer system – although it’s less clear to what extent these optical advantages are weakened, once one makes the payments refundable.  And of course 2012’s “47 percent” meme reflected a related part of the optical downside of formally netting transfers against income tax payments.

A broader issue – especially if refundability is inevitably limited and if there is some optical lean in the "income tax system" towards using exclusions and deductions rather than fixed-percentage, refundable credits – is that it may be hard to use this means when directing significant transfers to people on the very bottom.  Plus there is the vexed question – central to the anti-poverty debate – of what role work should play in the design of the programs, not to mention household structure such as number of kids.  These issues arise no matter what formal system one uses.

Suppose we had a uniform demogrant for all U.S. individuals, financed through explicit tax rate increases that were very limited at the bottom of the income scale.  In the typical language of public economics, this would not reduce “incentives to work,” which depend purely on marginal rates.  But in the typical language of anti-poverty discussion, the income effect of the demogrant would indeed reduce “incentives to work.”  That is, recipients would no longer face as dire a threat of privation (including starvation, assuming no other transfers) if they decided not to work.

This is not a case where one side or the other in this language mismatch is logically in error – it’s a question of how you want to use the term “incentive to work,” which  depends on what one cares about.  This in turn can depend not only on one's underlying normative views but also on empirical assumptions.  For example, a pure utilitarian would not care about "rewarding work" or 'helping the most deserving" as an end in itself, but might believe, depending on the empirical evidence, that in practice inducing work was either very important or not important at all (or anything in between).

The EITC is a sufficiently interesting and important provision to need substantial consideration all on its own.  In one sense, it’s “anti-insurance.”  Suppose that A and B, both poor, are both seeking scarce jobs.  A succeeds and B fails.  A is therefore better-off than B - not only does he have more income, but they both wanted the job.  With an EITC, A is then the one to reap further rewards from government transfer policy.  Purely from a static insurance standpoint, this makes no sense.

But on the other hand, suppose there are important reasons for encouraging work and “making it pay.”   Then the EITC’s anti-insurance structure can indeed be defended.

Making the picture more complicated still, one really wants to figure out (among other things) the overall marginal tax rates that actual or potential EITC recipients face.  At the same time that the EITC offers a large work subsidy, they may also be facing substantial positive implicit tax rates from the phase-out of various income-conditioned benefits.  Then later on, when the EITC begins to be phased out, the affected taxpayers either may or may not still be facing high implicit marginal rates from other phaseouts.  (These things vary with the taxpayer and by state or locality.)

Anyway, these are interesting and important issues that merit a lot more time and attention than I can offer here while catching up on my blog posts in the late stages of a busy semester.  But it was nice to have a session devoted to it - we hadn't done much distribution so far this year.

Tax day

As usual, I filed early via Turbo Tax.  I gave up doing it by hand some years ago, for reasons that include:

(1) Potential alternative minimum tax liability if you live in a high-tax jurisdiction such as New York, California, or Washington D.C.  Whether one ends up owing it or not, what a hassle to have to do the computation.

(2) The nightmare of, say, forgetting $100 of gross income until you are almost done.  With Turbo Tax, you just enter it and the computer does the rest.  If you're preparing your return by hand, any calculation that depended on adjusted gross income has to be redone.

(3) The last time I did it by hand, there was some insane rule for capital gains, such as trivial mutual fund passthroughs, that related to tax rate changes and special rates. The IRS (through Congress's fault, not its own) had to come up with a form that required something like 15 calculations that I recall as being on the order of, "Take 19% of the amount on line 5, and subtract it from 23% of the amount on line 7.  Then take the square root of the absolute value of the difference, round it to the nearest integer, and enter it on Line 12."

OK, I am admittedly exaggerating a bit on that one.  But only to convey a Deeper Truth.  I do indeed recall finding that, even though each calculation was mechanical, it was very hard to avoid an error (and thus to replicate the result) if one was doing very many of them in a row.

Turbo Tax, here I come, I decided - even though I have subsequently learned that this company may not be the world's best-faith political actor.

But not everyone files early, whether with Turbo Tax or not.  Yesterday (April 14), as I took a late night flight from California back to NYC, the man seated next to me appeared to be doing a federal income tax return on his laptop.  Good thing it wasn't April 15, as our plane was delayed and landed after midnight.

Activities on the side

Some tax shelter-related litigation in which I was an expert witness on behalf of the government has just apparently settled.  You can see an article discussing the case here.

In the words of the article, the case concerns “Texas billionaire banker Andrew Beal …. [and] relate[s] to Beal’s use of an abusive tax shelter the IRS calls Distressed Asset Debt, or DAD, to manufacture billions of bogus tax losses from junk Chinese debt…..

“In a DAD shelter, a U.S. taxpayer forms a partnership with a foreign owner of non-performing loans and then claims huge tax losses from the partnership—losses the foreign lenders, but not the U.S. taxpayer,  sustained.  The DAD technique spread among the wealthy in 2001, 2002 and 2003 after the Internal Revenue Service began a crack-down on better known abusive tax shelters, such as Son of Boss ….

“In 2004, after the IRS got wind of DAD, Congress changed the tax code to explicitly bar partnerships from being used to transfer foreign losses to U.S. taxpayers. Meanwhile, the IRS began auditing existing DAD partnerships, disallowing all their losses as shams and slapping on penalties…..

“Beal had created four separate DAD partnerships in 2002 and 2003 to hold non-performing loans made by the Chinese government, with the aim, the government says, of stockpiling $4 billion in artificial losses to shelter income.  (Even for Beal, whose net worth is an estimated $11.3 billion, $4 billion can offset income from more than a few years.)….

“[In an earlier case, the district court and Fifth Circuit]  nixed Beal’s attempt to claim $1.1 billion in tax losses from an investment of just $19 million in distressed Chinese debt, finding ... that the partnership was a sham that should be disregarded for tax purposes.  But the [courts] also ruled that Beal’s acquisition of junk Chinese debt had 'economic substance' because—and this sounds bizarre if you’re not a tax geek—he had a reasonable chance of making a real profit, even as he angled to claim big losses.  As a result …. both the district court judge and the appeals panel held Beal wasn’t liable for any penalties because he had opinions from both a  law and an accounting firm concluding that it was more likely than not that the partnership ploy would withstand IRS scrutiny. The appeals court called it a ‘close issue’ ….”

The issue this time around was simply whether Beal should face penalties for subsequent years’ disallowed deductions from DAD transactions.  Returning to the Forbes article:

"The government … has maintained that the circumstances of Beal’s three other DAD partnerships and in later tax years might be different—and more penalty worthy.

“Each side had already paid a big name tax professor to deliver an expert opinion on whether Beal could rely on those ‘more likely than not’ law and tax firm opinions to escape penalties.  New York University Law Professor Daniel N. Shaviro wrote for the government that the opinions in 2003 and beyond were weaker because they were based on 'factual premises that had been rapidly losing credibility.'  Specifically, they assumed that since Beal had made profits in distressed U.S. assets, he could reasonably expect to make money in the Chinese debt— which wasn’t turning out to be the case.  University of Chicago Law School Professor David A. Weisbach, whose expert opinion helped Beal escape penalties in the Southgate decision, weighed in again for his side.”

Anyway, this case has now been settled and there won't be a trial.

Monday, April 14, 2014

Back online soon

I haven't posted for nearly two weeks due to family issues that required attention but that are now pretty well stabilized.  Within the next couple of days, however, I plan to post concerning Susannah Tahk's paper at the NYU Tax Policy Colloquium last week, Nirupama Rao's paper tomorrow, perhaps the delights of April 15 (though in California at the moment, I e-filed early), some news concerning recently settled litigation in which I was an expert witness, and a book event at NYU Law School later this month.  Plus at least one other event at NYU that I'm looking forward to, along with a couple of upcoming appearances in Europe that I have on my calendar.

The problem with saying more at the moment is simply that I find my iPad a bit suboptimal for writing and editing posts, and left my laptop home in order to be more streamlined.

Wednesday, April 02, 2014

NYU Tax Policy Colloquium, week 9: Andrew Biggs' Public Employee Pensions: Investment Risk and Contribution Risk

Yesterday, Andrew Biggs of AEI presented the above-named paper.  (Title at page 1 of the link appears to be different, but it actually is indeed "Public Employee Pensions: Investment Risk and Contribution Risk.")

The paper addresses the funding issues posed by defined benefit (DB) plans for state and local government employees around the country.  This issue is a well-known time bomb that will either explode or else not, possibly in the near future, depending not only on what's done but also on the plans' good versus bad luck with their investments, many of which are in risky equity.

Currently the DB plans are estimated, if I recall correctly, to have about $1 trillion in present value of promised future benefits that remain unfunded.  However, this is based on discounting future benefits at a relatively high discount rate, which makes them look smaller.  The high discount rate (say, 8%, although it varies with the plan) is based on the expected rate of return from fund investments, which often are quite risky.

Given this actuarial convention in making the estimates - which isn't permitted for private sector DB plans that are subject to ERISA - suppose a DB plan is investing its assets at a very safe 2% rate.  It will appear to have very high unfunded liabilities, since they will be valued using this 2% discount rate.  The plan's managers decide, therefore, to bet the ranch.  They shift to very risky investments with an expected return of, say, 8% or 10%.  But this is not free money, of course.  The market values the underlying assets the same as the stodgy old 2% assets, because these items could hit a home run, on the one hand, or blow up, on the other.

Was this a wise investment choice by the plan?  Very possibly not, since the downside would leave it with gigantic unfunded liabilities.  But if I understand correctly how things are being done, the shift would cause the plan to appear as if it were much better-funded, because it could now use the 8% or 10% rate to discount its future liabilities.  This can both create dubious incentives, and mislead the audience for funding estimates to overlook the risk of the downside scenario in which the pension plan would end up being very short-handed.

The paper focuses on the question of how investment risk should lead us to think about the DB plans' future prospects - in particular, the risk that, if the plan investments do badly, there will either be defaults (or at least unexpected cuts) or a need for greatly increased contributions by workers or employers.  In particular, based on a Monte Carlo simulation where assets such as stock are assumed to have an 8% expected return (or lower in one of the scenarios), with a 12 percent standard deviation, it evaluates probabilities for insolvency, required contribution volatility, etc.  In particular, it offers parameters for the unsurprising, if disappointing, conclusion that you can't keep current contributions low and use risky assets to juice the expected return without creating significant contribution volatility and default risk.  In other words, using riskier assets fails to offer a free lunch in the paper's simulations (although it does of course turn out nicely for DB plans' stakeholders in the set of cases where the investments do well rather than poorly).

The quatrilemma whereby you can't have low contributions, plus long adjustment periods to make up shortfalls, plus low contribution volatility, plus low default risk, is based on presuming that a theory to the contrary that the DB funds' proponents and stakeholders sometimes advance is not in fact correct.  This is the theory that mean reversion in stock market returns means that long-term players, such as state and local governments if they can weather the interim storms, actually do get a free lunch in the form of higher expected returns without greater long-term risk.

To illustrate, suppose that we thought the stock market really was pretty much a lock to earn, say, 8% over time.  Then, if you can wait long enough, you can capture the higher return without bearing the variability that torments more short-term players.  For this to be true, however, periods of lower or higher returns must not be merely diluted, but positively offset.  E.g., if the market's been returning only 6% for a while, it's now likely to earn more than 8% for an offsetting period that gets it back on track.

Conceptually, it's as if an honest coin that yielded 5 straight heads is now likely to even things by running more tails for a while.  But admittedly the stock market is a sufficiently complicated beast (e.g., given the role played by market psychology) that we can't rule it out as decisively as we could in the coin example.  Still, it would require a rather odd market inefficiency that you would expect savvy investors to exploit.  (E.g., if the market is due to start earning an unusually high rate of return, the price level ought immediately be bid up to the point where we are back to the normal rate of return.)

I'm certainly open to theories of market inefficiency.  But, while this really is not my area, mean reversion does not appear to me to be among the more plausible candidates.  (And indeed I gather that Bob Shiller, who has gotten a Nobel Prize for writing about market inefficiencies, does not believe in it.)  For now it's just worth noting that, with mean reversion in stock prices or even a little bit of it, the dilemmas (or, rather, trilemmas and quadrilemmas) discussed in the Biggs paper might become at least slightly less binding.

Insofar as the existence of some or any mean reversion in relevant asset prices remains uncertain, I suppose you could say that supporters of the DB plans' current investment strategies and actuarial reporting conventions are taking a risk that they actually aren't taking on as much risk as they seem to be.  And even if the resolution of the second-order risk remains ambiguous, we will certainly learn at some point how their first-order risk-taking has come out.