Tuesday, December 12, 2017

What does it mean to have "guardrails" if there is no underlying theory of who should get the benefits and why?

I've been thinking about the issue of "guardrails" in relation to the passthrough rules in the House and Senate bills, with regard to whom they are supposed to keep out.

The problem I'm having in thinking about it is that, since there is no coherent underlying theory regarding who should get the benefit and why, it becomes difficult to figure out who would be getting it "improperly," and contrary to legislative intent, if we require defining such intent at a more general level than "industries that are friendly with the Congressional Republicans."

Let's take the underlying question of how the special rate for passthroughs relates to labor income, or wages in the economic (as opposed to the legal) sense. Wages in the legal sense don't get the special rate, but is it supposed to be for people who are providing labor income (even if combined with the use of capital) in the economic sense? Note that labor income in this sense, of course, extends to thinking about how to run the business, making decisions about its possible expansion, etc.

Both the House and the Senate bills appear to gesture in the direction of trying to reduce its association with doing work. But they do so ineffectively. The House bill has the supposed guardrail of reducing the benefit if you materially participate as defined by the passive loss rules, which would mean that the mere idler who owns a perhaps inherited business and trusts the hired hands to run it does better than the one who actually works.

But what's the reason for rewarding the idler? Doesn't it have something to do with decisions we think this person is making, which again is a form of work?

Note, BTW, that the passive loss rules were written to dampen the use of claimed managerial oversight as a mechanism for establishing material participation. But if you go back to the 1986 legislative history of the passive loss rules, you will see that this was based on a concern that people could fake exercising managerial oversight that was actually de minimis. (E.g., you just rubber-stamp whatever the folks whose business it actually is tell you to rubber-stamp.)

Then there is the exclusion in the House bill for personal service businesses. I have tended to interpret this as just reflecting that the House Republicans aren't particularly good friends with lawyers, doctors, consultants, etc. They are better friends with the real estate industry, the oil industry, etc. But there's a fig leaf on it of trying to sort out what's purely labor income - except that the people in the favored industries really have predominantly labor income too, at least if one defines it in the economic sense and they are actually running their businesses (not skiing in Gstaad while daddy's henchmen run the business).

We get to the Senate bill, and the personal service industries get some moolah from the provision until one's taxable income gets too high. And one doesn't get the special rate for W-2 wages that are actually paid, so long as they are reasonable compensation. But there's no requirement that one pay reasonable compensation - one can underpay oneself and get the passthrough deduction so long as one otherwise qualifies. So it taxes labor income favorably, so long as you aren't stupid enough (or constrained by liquidity concerns) to pay it to yourself as formal wages.

The whole thing also really has nothing to do with taxing "capital income" at more favorable rates than labor income.  The way to lower the tax burden on capital income, relative to a pure income tax, is to have expensing or its equivalent, not to tax interest income or the normal return, etc. The tax bills do this to a degree, e.g., by allowing a lot of expensing (plus interest deductions to make some capital income affirmatively subsidized rather than exempt!), although they don't exempt interest income.

But the favorable rate for passthroughs really has almost nothing to do with any of this. Again, those businesses are getting expensing, and if they're getting extra-normal returns (rents in economic lingo), without which all this becomes less interesting, then taxing these returns is efficient.

So one main aspect of the passthrough rule is a special, lower tax rate for labor income when it's done through a passthrough, the definition of which is pretty much circular (you qualify if you qualify, and it's hard to see why in terms of an underlying theory). Plus, Junior at Gstaad gets the special rate, reflecting others' past labor income that presumably is continuing to play out nicely, and again it's not quite clear why.

Against this background, what exactly is the guardrails' proper reach? It's quite hard to say when the underlying theory in support of the rules is so lacking. By lacking, of course, I mean not just incorrect but incoherent or nonexistent.

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