Tax policy colloquium, week 6: Leandra Lederman's Of Risks and Remedies: Best Practices in Tax Rulings Transparency

Yesterday at the Tax Policy Colloquium, Leandra Lederman presented her paper, Of Risks and Remedies: Best Practices in Tax Rulings Transparency. (I'm not including the link because we discussed an early draft.)

 

The paper looks at the issue of confidentiality versus disclosure with respect to private letter rulings (PLRs), which a tax authority issues to a particular taxpayer, definitively setting forth how a particular transaction will be treated under its tax laws, but generally without precedential effect on other cases.

 

The paper responds in particular to two distinct episodes in the history of PLRs. The first is American, while the second relates to Luxembourg.

 

In the United States, PLRs were long treated by the IRS as confidential. Taxpayers and their advisors weren’t barred from disseminating them as they liked, but the IRS itself would not do so. The IRS rationale was that there were administrative advantages, to both taxpayers and the IRS itself, to settling particular questions in advance so that everyone could go forward. But because doing this in any helpful volume required allowing lower-tier IRS personnel to greenlight particular rulings, the agency was anxious not to allow for any appearance that these were legal precedents that taxpayers could follow against the IRS. To this day, for this reason, PLRs state on their faces that they do not have precedential value, cannot be relied upon other than by the taxpayer to whom they were issued, etc. But the IRS felt better still if there was no publication of them. (Taxpayers often had no reason to share their rulings with others.)

 

This led, however, to insidious practices. For example, insider law and accounting firms that did a lot of rulings business with the IRS had their own libraries of PLRs, which perhaps they swapped a bit when both sides had enough to make it worthwhile. The tax shelter in the infamous Knetsch v. U.S. case was based on a PLR that the promoter had evidently extracted from a naïve lower-level IRS decisionmaker, and then used as a marketing tool to sell more of the same.

 

Eventually Tax Analysts, the publisher of Tax Notes, sued under the Freedom of Information Act, and ever since PLRs have been published, albeit with redactions that aim to preserve the anonymity of the taxpayer. But this policy has not, despite another Tax Analysts lawsuit, been extended to Advance Pricing Agreements (APAs), which are basically PLRs that address transfer pricing issues. These ostensibly are too fact-intensive and particularistic to have the same dissemination value – a conclusion with which the paper does not agree (nor do I).

 

So that’s the American thread of the paper: looking at this history, evaluating the pros and cons, offering a typology re. how to think about the issues, and proposing at the end that APAs be publishable like PLRs, with suitable redactions.

 

Now to the Luxembourg story. As Omni Marian has helpfully figured out (cited in Leandra’s paper), Luxembourg was for some years issuing private letter rulings with next to no effort to do a bona fide tax analysis, as a way of helping EU companies avoid EU taxes. Here is a representative example (again, taken from Omri’s work):

 

Say that Deutsch-Co (DC), a German company, wants to invest €100 in a French subsidiary, DC-France, in the expectation of earning €10/year that will annually be paid over to DC. If DC invests using equity, DC-France’s €10 payout will be a dividend, nondeductible in France but exempt in Germany, so its €10 of income will be taxed just in France. If it invests using debt (and let’s assume, but ignore for arithmetic simplicity, that DC uses enough equity to avoid thin capitalization rules), the €10 of interest zeroes out DC-France’s net income but is taxable in Germany.

 

The trick to avoiding taxation in either country – cross-border tax arbitrage, aka hybridity – is to come up with an instrument that France deems debt and Germany deems equity. Not necessarily impossible, at least in years past (before OECD-BEPS), but also perhaps not so easy. So Luxembourg would insert itself as an accommodation party. DC would invest €100 of equity in DC-Lux, DC-Lux would invest €100 of debt in DC-France, and Luxembourg would issue a PLR misclassifying DC’s stake in DC-Lux as debt (for Lux tax purposes). So taxable income is zeroed out by interest deductions in both France & Luxembourg, but Germany, “rightly” classifying the stake in DC-Lux as equity, would still classify the €10 payment as equity, so DC ends up paying tax nowhere.

 

What’s in it for Luxembourg? Rather than the numbers matching exactly as in my simplified example, the DC-Lux conduit would net a slight spread between the cash flow entering and that going out again – say, less than 1% of the total amount of income that is being sheltered. That would be taxed at Luxembourg’s 29% rate. So they’d get a nice little fee, tied to the total amount of income that was being sheltered, for their accommodation services via the PLR.

 

This is quite a different type of example from the US-only scenarios described above. In particular, there’s a strong case that Luxembourg benefits from doing this due to the negative revenue spillover to Germany and/or France, for which it is compensated. If so, then the secrecy may help Luxembourg as well (even if other countries know in general terms what’s going on). The exposure of such previously secret rulings in the Lux Leaks scandal were therefore at least arguably bad news for Luxembourg, whereas for Lux rulings covering purely internal matters there would be no reason for presuming ex ante that secrecy was nationally beneficial.

 

For this reason, I see the cross-border and same-country examples as importantly different. This is probably the direction in which the paper draft is going – I gather that Lederman has a lot of interesting research into the Lux situation that was already excised here (partly for length reasons) and that may end up in a separate paper.

 

With all this as background, the article has two main aspects. The first is to establish a very useful typology of the types of issues raised by PLRs et al in terms of the societal interests (and the benefits or costs for particular types of taxpayers and professionals) associated with greater versus lesser secrecy. It’s off to an excellent start in that regard, although I’m urging greater use within the categories of insiderism as a key analytical issue. Second, it argues very persuasively for greater transparency and less secrecy, albeit with redactions insofar as they are needed to protect valid taxpayer concerns about confidentiality. Two especially significant aspects of the paper’s recommendations are its urging:

 

1) that APAs issued by the IRS be disseminated publicly along similar lines to those governing PLRs, and

 

2) that the adoption of generally US-style publication approaches for PLRs be at least seriously considered in other countries.

 

It’s nice, at a time like this, to be reminded of something that the US might currently be doing better than peer countries.

The big New York Times story on Trump's taxes

 Yesterday I feverishly wrote under a short time window, and then posted via the kind offices of justsecurity.org, a short analysis of the big New York Times story regarding Trump's taxes. You can read it here.

This will be an ongoing NYT story, as they have promised follow-ups. Day 1 was an overview, but there will be deeper dives into multiple issues over the next few weeks.

A question I DON'T address in my commentary is: What does it tell us about the U.S. federal income tax system?

A common answer is: It shows how badly screwed up the system is. But I actually don't agree. Or rather:

(1) It shows how badly we have miscarried on the auditing and enforcement side, and

(2) I'm not saying that the system is good. It's just that almost nothing here shows what is wrong with it, OTHER than  the egregious enforcement failures.

Trump succeeded in paying very little tax for two main reasons. The first is that he is a clown, hence he kept losing large sums of money. It's not unreasonable to allow, as our system generally does (albeit with restrictions responding to abuse concerns), losses in one year to offset income in other years. The putz actually lost millions of dollars because he is under-qualified to run a corner grocery store. Give him money to play with, and he rapidly loses it through stupidity and vainglory.

The second is that he took a lot of tax positions on his returns that look as if they could not withstand the slightest scrutiny. For example, he appears to have blatantly mischaracterized personal expenses as business expenses. But that is an inherently hard line to draw, and is fact-specific. As a matter of design, not only income taxes but consumption taxes inevitably run into this problem. (In a VAT, the parallel issue might have been labeling consumer purchases as business inputs.)

Likewise, when taxpayers compute their business proceeds, it's reasonable to allow consulting fees to be deducted, but this gives them the opportunity to lie by adding in fake consulting fees that are actually, say, gifts to one's kids. The solution is auditing and stiff penalties for fraudsters. Throw some of these folks in jail, and their tax advisors too if they were involved.

The probably unmeritorious $72 million refund is in a slightly different category. As I discuss in the above piece, its permissibility depended at the time on a sharp distinction between an asset that has lost all of its value, and one that has merely lost almost all of its value. But even so, proper auditing ought to have sufficed here as well.

BTW, the apparent reason THAT claim got audited is that requests for large cash refunds automatically draw a special auditing and review process. Had the numbers played out differently in a year-to-year sense, while adding up to the same multiyear sum total, there is every reason to think that it would have evaded all scrutiny (until now) as well.

Trump is in all respects a tribute to the collapse of white collar law enforcement. He would have gone to jail decades ago, and probably for a good long stay, if such enforcement had not collapsed politically because white collar criminals have money and friends. The income tax story from the NYT is part and parcel of this. Even before the recent sharp decline in serious IRS auditing of rich people and big corporations, the fact that someone can cheat after year, almost in broad daylight, without running into the minimal review that would have been needed to demand major adjustments (and probably to apply significant penalties), and where this is based mainly on abuse of the line-drawing issues that an income tax inherently faces (and that, in many cases, a consumption tax would face as well), the end result is an indictment of our system, all right - but just on the auditing and enforcement end.

Tax policy colloquium, week 5: Henrik Kleven's The EITC and the Extensive Margin: A Reappraisal

 Yesterday at the Tax Policy Colloquium, Henrik Kleven presented his paper, The EITC and the Extensive Margin: A Reappraisal.

This paper challenges the previously prevailing view that the earned income tax credit (EITC), at least when it was significantly expanded in 1993, had significant positive labor supply effects at the extensive margin (pertaining to whether or not one worked in a market job, as distinct from how many hours one worked). It notes that all EITC changes other than that in 1993 seem not to have affected employment levels among low-wage workers, despite the positive substitution effects that it should have in the phase-in range (and indeed, at the extensive margin, until full phase-out).

As to the 1993 change, it finds that the previously claimed positive employment effects appear better attributable to two confounding (from a statistical measurement standpoint) sources of employment gain from the same era. The first is the enactment of welfare reform. The second is the era’s booming economy. The paper finds that the era’s employment gains from that era better fit welfare reform and the booming economy, and in any event cannot with any confidence be attributed to the EITC change, especially given evidence from all the other EITC changes.

Why would the prior literature have gotten this wrong? Disentanglement is indeed extremely difficult, and empirical techniques have improved since some of the earlier papers were written. Plus, economists may naturally expect that people will respond to incentives, even if, with respect to real labor supply, it is not so clear that we should expect to see this at any significant level. There also may be publication bias against papers that fail to find a significant response of a given X to a given Y.

However, the topic of this particular paper makes it no-response finding highly controversial. Many people on both the left and the right would like there to be a positive response. On the left, the fact that the EITC has greater potential political support than, say, unconditional cash grants – because it only goes to the working poor, who are less easily slandered than the rest as “undeserving” – can make attacks on its efficacy at the extensive margin quite unwelcome. On the right, while scoundrels may want to deny all aid to the poor no matter what, those who are acting in good faith may be glad that there is a poverty relief program they can point to, and that (previously at least) was thought to have effects that they may not just welcome but consider vital.

The Wall Street Journal added gas to the flames surrounding this paper by publishing an editorial that said: Given the paper’s findings, we no longer support the EITC. This was transparently disingenuous on the WSJ’s part, given the utter impossibility that papers showing low responsiveness to taxes’ substitution effects would ever affect its views of taxing the rich. But the WSJ’s eagerness to advance its top-down class warfare by citing the paper certainly helped to show the temperature-raising stakes here.

I am not an empiricist, but I found the paper’s empirical analysis very impressive. Empirical debate should and will go on, but this is a major contribution that appears to me to move the needle a bit. But that said, how should it affect one’s views of the EITC? These should not, after all, turn just on the EITC’s labor supply effects at the extensive margin. So here are some thoughts on the surrounding issues.

1) Why seek to increase low-wage labor supply, and how much does it matter to the EITC’s merits? From a standard neoclassical standpoint, labor supply is merely a commodity choice between (a) the market goods that one can buy with wages, and (b) “leisure” in the economist’ sense. (I add the scare quotes because, say, raising a couple of young children in lieu of taking a market job is not exactly “leisure” in the layperson’s sense of the word.) So why tilt the commodity choice towards working more?

One reason for doing this might be that low-wage workers face high implicit marginal tax rates in other respects, such as by reason of the phaseout of income-conditioned benefits. So here the point would not be more work for its own sake, but making the overall labor supply choice in this range more neutral.

A second reason would be the view that positive internalities and externalities strongly support increasing low-wage labor supply. Hence, according to this view, one might not only want to subsidize work, creating substitution in its favor, but also induce it via income effects (by not giving able-bodied people enough to live on unless they work).

While that view may have some merit, at least in some cases, I think we should also keep in mind that low-paying jobs (a) are often quite miserable, and are not always good stepping stones to something better, and (b) may compete with other valuable uses of one’s time, such as spending time with one’s own young children, e.g., in a single-parent household.

If one would favor unconditional cash grants – the position towards which I lean – then a lack of positive labor supply response to the EITC is nowhere near fatal. So long as the EITC can’t be traded in as a political matter for more cash grants – i.e., so long as the legislative counterfactual is simply less aid to the poor – the program still has merit.

That said, one should keep in mind the EITC’s second-bestness insofar as one favors more aid to the poor without conditioning it on labor supply. From a behind-the-veil standpoint, the EITC is social insurance against the risk of being a person who can only earn low, rather than high wages. But it is anti-insurance as between poor people who succeed in finding jobs vs. those who fail, rewarding the winners and offering nothing to the losers.

2) Broader lessons – Why doesn’t substitution seem to matter here, assuming that one accepts the paper’s empirical findings? The two main suspects here are (a) generally low real labor supply elasticity, and (b) the EITC’s complexity and lack of salience. Based on (a), does it offer indirect support for taxing the rich at high levels, even though that is admittedly a different population? (And one with greater access to formal tax planning responses.) Based on (b), should the EITC be revised or else replaced with means of offering cash support to low-wage workers that are more transparent and salient?

Upcoming Zoom event on Literature and Inequality.

On October 15, at 4:30 pm EST on Zoom, I'll be discussing my recently published book Literature and Inequality, with commentators Kenji Yoshino and Branko Milanovic.

The invite with Zoom link is here, and you need not respond in advance in order to attend.

Tax Policy Colloquium, week 4: Adam Kern's Illusions of Justice in International Taxation

 Yesterday at the Tax Policy Colloquium, Adam Kern presented his paper, Illusions of Justice in International Taxation. It is a chapter from his Princeton Politics Department dissertation in process (in the realm of political theory) entitled Principles of International Taxation. Kern is also an NYU Law grad who took the colloquium a couple of years back. The project aims to bring philosophical principles and expertise to bear on international taxation – to date a very under-inhabited field by philosophers, although a few, such as Peter Dietsch, who appeared at our colloquium a few years back, have been working in it.

The project, like Liam Murphy’s and Thomas Nagel’s The Myth of Ownership, has both what one might call a destructive or ground-clearing component – aiming to clear away ill-reasoned implicit philosophizing in the field – and a constructive one, aiming to erect something else in its place.

The chapter we discussed is mainly concerned with ground-clearing. As such, like Murphy-Nagel, it has relatively little to say to the likes of me, since I already agreed with its critiques of what I would agree are ill-founded and ad hoc normative principles. Nonetheless, it may make a significant contribution to the field, given that those principles may be far more widely accepted than I tend to realize. I tend to focus on their proponents’ complementary arguments that raise consequentialist and indeed welfarist issues.

The project differs from, without contradicting, my international tax writings in that it is centrally concerned with exploring what would be a globally just international tax regime. My work generally takes for granted national “selfishness” (i.e., exclusive or nearly exclusive concern with the welfare of one’s own people), not because that is necessarily morally defensible, but because it’s the world we live in & which mainly interests me. I do think about multilateral cooperation to achieve better end-states, insofar as it appears to be feasible or sustainable within the selfish framework, and I also consider the possibility (since it appears to be realistic) that countries may value cooperating rather than defecting in a prisoner’s dilemma-type setting, even if they could get away with more defecting than they undertake, so long as they believe that others tend to be similarly minded. But that still is very different than asking what a given country would do if it accepted that global justice should guide its actions.

Okay, turning to the paper itself: It discusses the Capture Principle, which it defines as holding that (i) countries have a package of rights to tax income generated from activities inside their borders, and (ii) the value of the package should be proportionate to the amount of income generated from such activities. Put more in everyday language, I would say that the Capture Principle holds that source-based income taxation is just. Hence, countries not only can (and perhaps even should?) justly engage in it themselves, but should accept the justice of other countries doing so as well. The paper rejects this principle, and a subsequent chapter apparently does the same for the Affiliation Principle (and hence for residence-based income taxation).

At least from this chapter, it is not entirely clear to me what a given country that currently is engaged in source-based and residence-based corporate (and other) income taxation should do once it realizes that the Capture and Affiliation Principles are wrong. And the project does not rule out the possibility that these approaches could be largely sensible in practice, albeit as interpreted and modified to further, rather than set back, global justice. But they don’t stand on their own as inherently just or as having more than contingent and instrumental value. By analogy, consider the Murphy-Nagel rejection of entitlement to one’s own market-derived labor income as inherently just. This does not contradict viewing market arrangements as having desirable incentive effects that might lead to a system in which people’s after-tax returns are generally strongly affected by the level of their pretax earnings.

Very quickly, the chapter’s main arguments can be summarized as follows: Proponents of the Capture Principle, as applied to the source-based taxation of foreign multinational companies (MNCs), base it on a notion of reciprocity between the MNCs’ foreign owners and their domestic customers. (As an aside, I would tend to think of the relevant reciprocity as more between different countries’ governments, acting on behalf of their own residents.)  But all their arguments fail, even if one accepts arguendo their underlying moral premises.

First, the Principle of Fair Play, which abhors free-riding, posits that, since the MNCs are benefiting from locally created public goods and infrastructure, they have a moral obligation to contribute to funding it. The paper argues, however, that merely positing a duty so to contribute does not show that such contributions should depend on applying source-based corporate income taxation. What ought to be contributed is indeed the very question at issue.

Second, the Compensatory Principle finds a moral obligation to reimburse the source jurisdiction for the (marginal?) costs imposed by the MNC’s inbound activity. As an aside, I have always found this frequently-heard argument peculiar, because countries generally want inbound investment and consumer goods, based on their considering these things net benefits to themselves, not net costly. Arguing that it’s only fair to reimburse costs is a bit ill-directed to the circumstance of perceived net benefit. This is why countries typically welcome inbound investment, as well as inbound consumer goods unless they are being protectionist, even if they would also like (subject to concerns about tax competition) to get some revenue.  However, since the paper is generally accepting arguendo the contested principles’ underlying premises, it emphasizes the fact that marginal cost imposed is so ill-related to domestically sourced income. It contrasts, for example, an MNC that sends heavily laden trucks along a country’s roads, in the course of generating only minimal profits, with one that makes a ton of money through derivatives trading.

Third, the Contributory Argument, in two different flavors, purportedly supports source-based corporate income taxation of foreign-owned MNCs. In its proprietary version, it notes that, if countries rightfully have the property right to exclude outside access from their physical space and consumer markets, a source-based corporate income tax follows from that. The paper responds that there may be no particular reason why the access fee would take that form. (But might it be a permissive form?) In its distributive version, the contributory argument asserts that nations are entitled to their shares of the global surplus that they help create, ostensibly justifying the use of a source-based corporate income tax to realize that rightful claim. The paper responds that the creation of global surplus is simply too intermingled among all nations to allow for treating source-based income as a proxy therefor.

A war fought on enemy territory – Again, in all these cases, the paper accepts arguendo lines of argument that the author may not accept – and, in one case, expressly states in a footnote that he does not accept – in order to show that, even if  the broad principles are valid, the conclusions don’t follow.

Two other arguments that it appears to accept arguendo – and that I myself don’t accept, very likely with the author’s agreement – are that (1) the geographical source of income can meaningfully be determined, at least in principle, and (2) for the distributive version of the Contributive Argument, that (a) allowing producers to reap the full market prices from what they offer is not just potentially efficient but also independently just, and (b) that this just claim transfers from a given individual to his or her country. In common with Murphy and Nagel, I think of markets as being rightly favored in appropriate circumstances because of their efficiency properties in those circumstances, not on independent grounds of moral entitlement to the market values one is able to realize.

Accordingly, the chapter’s main structure is to attack propositions in the form A -> B, based on accepting A arguendo even though welfarists such as me (and also many non-welfarists, including Kern) would not accept A to begin with, other than conceivably on contingent empirical grounds.

The use of source-based corporate income taxation in international tax policy – Many of the paper’s rebuttals reflect corporate income taxation’s unrelatedness to rationales for taxing outside MNCs. The case for income taxation stands on views about tax burden distribution as between (resident) individuals. Its origins and rationale have nothing to do with the international setting. But once one has an income tax on resident individuals, one may have good reason for extending it first to resident corporations, and then to foreign corporations on what is deemed to be their domestic source income. Even if these two extensions make perfect sense, however, it would be a surprising coincidence if the income taxes thereby imposed on foreign MNCs happened to match the various rationales that have been extended for source-based taxation of outsiders.

But what are the proponents of the Capture Principle really (or mainly or also) saying? – While there are also reasonable consequentialist arguments in favor of source-based corporate income taxation, I agree that the views justifying the Capture Principle on separate moral grounds can be found in the literature. But I wonder if the paper takes them more seriously than one needs to – or perhaps, even than the proponents really take these arguments themselves. They often are trying to rationalize current practice, or else something close to it or plausibly evolved from it, rather than seeking to deduce in the abstract how cross-border taxation might work. So perhaps what they are mainly saying is that a system that assigns a large role to source-based corporate income taxation (a) is not wholly ridiculous, and (b) facilitates desirable multilateral coordination. E.g., all income is “taxed once,” even leaving aside residence-based taxation, if everyone has a source-based tax, their rules for it are reasonably consistent, and tax havens don’t end up with much under these rules because so little happens in the havens on either the production or the consumption side.

For myself, that claim is good enough, not to prove itself or resolve anything, but to help set up a framework for analysis, including by interrogating it, and potentially rejecting it in whole or in part on empirically rooted consequentialist grounds. Plus, again I’m personally interested less in the ideal, which I see as beyond practical reach anyway, as in thinking about how countries’ (and their political actors’) incentives and perceived interests shape behavior, hopefully in directions that might be better rather than worse from both a national and a global standpoint.

Thus, as with Murphy-Nagel (and this, of course, is good company), I view it as an allied and constructive effort that doesn’t speak as much directly to me as to others who may need to have their consciousnesses raised, so to speak.

Tax policy colloquium week 3: Natasha Sarin's "Understanding the Revenue Potential of Tax Compliance Investments"

Earlier today at the Tax Policy Colloquium, Natasha Sarin presented her paper (co-authored by Lawrence Summers), Understanding the Revenue Potential of Tax Compliance Investments.

The paper argues that restoring the IRS budget to a 2011-equivalent level, by increasing its budget by $107 billion over the next ten years (mainly for auditing and technological improvements), could increase federal income tax revenues by more than $1 trillion. It criticizes Congressional Budget Office estimates that are more conservative both in looking only at smaller budgetary increases, and in failing to include properly measured (or any) indirect revenue gains (i.e., those from taxpayers other than the ones who are actually audited).

 

A 10-1 Marginal Revenue Payoff from Increasing IRS Outlays – If we lived in a different world than the one we actually live in, the claim of a 10-1 revenue payoff here would verge on being self-refutingly absurd. So badly under-funding the IRS would require such gross negligence, verging on deliberate sabotage, that one really wouldn’t expect it. But in fact this estimate reflects a 20-plus year partisan war against the IRS that has not been waged in good faith. So it isn’t surprising at all.

 

Even absent the current partisan environment, however, one might expect Congress deliberately to under-fund the IRS. This offers two big advantages to members who are seeking reelection The big money folks in their districts or states don’t like being audited, and are presumably ready to put their money where their mouths are. And, if the IRS performs poorly because it has deliberately been under-funded, the under-funders can grandstand in front of ill-informed voters by holding hearings, complaining about it, etc.

 

Determining the Revenue Payoff – Again, the paper offers a rough ballpark estimate of $107 billion in IRS budget increases (over 10 years) as raising tax revenues by over $1 trillion. (Charles Rossotti has estimated $1.6 trillion.) This would mainly be backloaded in the 10-year estimating period, because it takes a while to ramp up. And there would be large revenue gains outside the 10-year window.

 

As noted above, the CBO excludes indirect revenues (much the larger piece) from official estimates, deeming them too uncertain. But this illogically responds to uncertainty with infinite discounting.

 

Excluding out-year revenues means that, after engaging in no present value discounting within the 10-year budget, one arbitrarily switches at the boundary line to infinite discounting. This is not an intellectually defensible approach.

 

Why stop at $107 billion over ten years and restoring 2011-equivalent revenue levels? – This may reflect political reality, but otherwise it makes no sense. Suppose one is still earning a 10-1 return on increased IRS outlays at the margin reached after the 10-year increase (which is only about $10B extra a year, after years of budgetary sabotage). Then it would be silly to stop there, although it is true that well-used budget increases might require first ramping up the iRS’s absorption capacity.

 

In describing how one might think about the question of just how high the IRS budget should go as the revenue payoff presumably (at some point) starts to decline, a useful structure is provided by the marginal efficiency cost of funds (MECF), first described by Slemrod and Yitzhaki in a 1996 article. Roughly speaking, the MECF from a given revenue increase = (Revenue + effect on taxpayers’ deadweight loss) / (Revenue – effect on government administrative costs).

 

Thus, for example, suppose the government raised $10 in tax revenues, and that the change increased taxpayers’ DWL by $3.50, while also costing the government $1 to collect. Taxpayers would be worse off by $13.50, while the government would have netted $9, so the MECF for this change would be 1.5.

 

The lower the MECF the better, all else equal. A perfect seamless lump sum tax would have an MECF of 1.0, and a Pigovian tax might come out lower. But real world tax instruments are likely to have higher MECFs that also tend to rise with the marginal use of the instrument.

 

Now suppose the government gets a 10-1 revenue boost out of increasing the IRS budget. The MECF for a $1 increase in the budget equals (10 + the effect on DWL) over 9. That yields a pretty low MECF unless the effect on DWL is high. But note that increasing IRS audits, while it would increase taxpayer DWL in some respects (such as requiring them to go through the audits), might also reduce DWL in some dimensions. Suppose for example, that it makes taxes, although higher, also somewhat more neutral because it reduces the effective tax preference for cheating and over-aggressiveness. It also might cause some taxpayers to give up the game and reduce costly evasion and avoidance effort.

 

Plus, it might increase equity in both the vertical and the horizontal dimensions. Given how little we audit high-income taxpayers, greater auditing might in practice make the tax system more progressive, while also increasing equality of tax treatment as between the honest and sketchy at similar pretax income levels.

 

MECF helps to show why one would want to stop well short of increasing auditing to the point where it broke even budgetarily at the margin. Suppose, for example, that a $1 increase in the IRS auditing budget increases revenues by only $1.01, because we have crossed over so far into the realm of diminishing returns. The MECF from doing this would be ($1.01 + effect on DWL) / .01, which does not look good at all.

 

Thus, in principle one should stop increasing audit levels (and other aspects of the IRS budget) when the marginal return, keeping in mind equity considerations as well, no longer looks good compared to alternative choices. But we would appear at present to be far, far short of that.

 

Additional points of interest raised by the paper

1) How would raising $1 trillion over 10 years in this way, mostly from high-income taxpayers, affect the merits of other proposed instruments for increasing progressivity, such as wealth  taxes or mark-to-market taxation? The answer, I’d say, is that this really isn’t an either-or choice. Those instruments should be used if (and only if) they score well enough in a distributional and efficiency-based analysis. Better IRS auditing capacity can cause such instruments to perform better than they otherwise would, however.

 

2) How should one account for budgetary out-years? The 10-year window, with its infinite discounting for things outside the boundary, is especially disastrous in cases, such as that of ramping up the IRS’s budget and audit capacity, where positive returns lie disproportionately outside the window. Curtailing the period of analysis does less harm when in-years and out-years are fundamentally alike. But it makes no sense to be as myopic as Congress deliberately is under existing budget rules. Infinite-horizon budget forecasting (under a defined set of policies that may not be sustainable) is a valuable intellectual tool, whether or not one wants to deploy it in official budget rules.

 

3) How should Congressional budgeting account for the revenue gains from increased IRS spending? Ignoring the gross revenue increases is nothing short of idiotic On the other hand, looking purely at the net revenue effect would turn net revenue-maximization into the implicit default, which isn’t quite right either.

Tax policy colloquium, week 2: Clinton Wallace's Democratic Justice in Tax Policy Making

 Yesterday at the colloquium, old friend (and former NYU Visiting Assistant Professor) Clinton Wallace presented his paper, Democratic Justice in Tax Policymaking.  

The article explores how to make tax policymaking more “democratically legitimate.” It notes critically that “various scholars and policy makers have sought to channel tax policy making away from democratic input and towards prescribed outcomes…. [T]hese moves are grounded in strands of public choice theory that are expressly critical of democratic decision making.” It favors instead empowering the normal majoritarian legislative process, while increasing its transparency and the information that is available to voters. Further details are available in the 3-paragraph abstract that you can find right at the front of the above link.

 

I give the article kudos for interrogating “our” elitism, i.e., that of tax policy experts who often believe (and I plead guilty) that their sense of what the tax system ought to look like is normatively preferable to what Congress is likely to do. However well-meaning we might be, we need to be healthily self-interrogating regarding our biases and inclinations.

 

I also wish to acknowledge upfront a possible criticism of my response to the paper. I wish I had a nickel for each comment I’ve ever gotten, on one of my papers, that took the form of “Why did you write the paper you were interested in writing, rather than the wholly different one that I (the speaker) was interested in reading?” This is usually a stupid form of comment, because both of those two papers might be worth writing, and one is entitled to follow one’s own fancy. So I hope I am not doing too much of that here.

 

1) Democratic legitimacy, democratic deficit

 

While the paper at this stage does not entirely define “democratic legitimacy,” I would think that this does or should have a whole lot to do, in present circumstances especially, with what is often called the democratic deficit. That, in turn, can be defined as an insufficient level of democracy in political institutions and procedures, in comparison with the theoretical ideal of democratic government.

 

That ideal, in turn, is of course is not self-defining. Indeed, one could read (or write) an entire library about it, and many have. But it brings to mind such concerns as the following:

 

(a) the relative political power held by different types of people and groups, which it suggests should not be too unequal. This is part of why vote suppression is so vicious and evil – no milder words will do – even leaving aside its effects on electoral outcomes. But one person, one vote is not enough to satisfy the theoretical ideal of not-too-unequal political power.

 

(b) whether majorities’ subjective preferences are being sufficiently honored (insofar as consistent with minority rights),

 

(c) whether the members of such majorities are getting what they would want with accurate empirical information. Fooling people into supporting self-harm, which they are then able to get because their candidate wins the election and then sets about robbing and immiserating them, does not meet democratic government’s theoretical ideal.

 

In my view, the democratic deficit is currently a seventy-alarm fire with multiple components. But one of them, predating Trump, is the empirical evidence adduced by the likes of Larry Bartels and Martin Gilens to the effect that the policy views of the bottom 99% have no discernible impact on most areas of public policy.

 

This is a key sense in which the focus on democratic legitimacy led me to expect a different paper. Removing delegations to experts and other means of limiting legislative majoritarianism, even when accompanied by offering voters more extensive information regarding, e.g., how their current year tax bills would change under proposed legislation (and who sponsored each provision in such legislation) doesn't strongly address what I consider the main sources of today’s gaping democratic deficit, even if one favors those changes. But perhaps this is just a labeling issue.

 

2) The “undemocratic impulse” among tax policy experts

 

In what I think is one of its signal contributions (whether or not one fully agrees), the paper criticizes what it calls the “undemocratic impulse” among experts to dictate outcomes that are (in their view) the best. This is a very useful phrase, given the need among even the most benevolently minded experts in a given area to be properly self-aware and self-interrogating. However, the paper attributes the “undemocratic impulse” to public choice theory, which I would question on 2 grounds: actual causation, and what public choice theory is / does. I would say instead that those who are subject to the “undemocratic impulse” may invoke public choice theory as an ideological tool. However, it can also be used to criticize actual democratic and majoritarian institutions from the standpoint of democratic government’s theoretical ideals.

 

(a) “Undemocratic impulse” (if that’s what it is) without public choice theory – Stanley Surrey, the famous Harvard law professor who invented the tax expenditure concept and served in JFK’s and LBJ’s Treasury Department, on his way to becoming the most influential tax academic in US history, notoriously favored delegating tax law details to experts, such as the Treasury Department staff. He was a firm critic of legislative majoritarianism in tax policymaking, as in his classic 1957(!) article, "The Congress and the Tax Lobbyist: How Special Tax Provisions Get Enacted."

 

Surrey notes here how interest group capture of the legislative process gives rise to sacrifice of the public interest, by reason of logrolling between different business interests and the disproportionate power of higher-income taxpayers. It’s almost pure Mancur Olson interest group theory, but without the theoretical apparatus and based on years of personal observation rather than any sort of a theoretical model (public choice theory or otherwise). Surrey’s view epitomized how idealistic experts very often view the legislative process, based in part on empirical knowledge that gets slighted in that process, albeit not from a purely “neutral” perspective as no such thing exists. Less clear, however, is whether this viewpoint is actually “anti-democratic,” or is based instead on observing how democratic institutions fail in practice to satisfy the dictates of democratic theory. Maybe some of each.

 

(b) Public choice theory – While it’s true that public choice theory can be used as an ideological tool by one who is hostile to public control over policymaking, it also (i) has aspects of science or logic, not just ideology, and (ii) can be used from a pro-democratic standpoint to identify flaws in how majoritarian institutions work in a mass society.

 

Consider Arrow’s theorem, which the paper groups among public choice theory’s “indictments of and attacks on democratic decision-making.” The theorem is simply logically true within its terms, like it or not, although what to make of it is of course another matter. But it does not “predict” that in practice there will be a lot of cycling between outcomes (indeed, its literature explores what might produce stability and/or particular outcomes). It also does not support viewing voters’ and legislators’ preferences (especially if we are thinking cardinally, not just ordinally) as normatively irrelevant.

 

Likewise, a democrat should be no less interested than an anti-democrat in the observations about interest group politics that Olson theorized and Surrey observed. The reign of narrow, concentrated interests over broad and diffuse ones is potentially invidious to satisfaction both of the majority’s interests and of its preferences.

 

3) Concrete proposals

 

In addition to favoring more legislative majoritarianism and less delegation to experts / insulation of policymaking from control by elected politicians – on which my preferences are more case-by-case than a priori, although I admit to having frequent sympathy for delegation where I feel it might work decently – the paper also favors a number of measures to strengthen Congress’s accountability by better informing the public. This is an aim I generally favor, although there is much to debate in the paper’s particular proposals. Indeed, one need not believe that measures of this kind can greatly increase democratic legitimacy and shrink the democratic deficit – given where we are these days – in order to view them as good things. One also need not favor more legislative majoritarianism, rather than less, in order to agree that, when elected politicians are directly controlling policy, transparency is vital even if less effectual than one might have wished. But given the length of this post, along with the clarity with which the paper presents these proposals, I will leave them to readers to examine on their own.

New Jotwell post on Boushey et al, Recession-Ready

 For a while I've been publishing annual very short pieces in Tax Jotwell, aka "The Journal of Things We Like (Lots)," which is a forum for bringing to broader attention recently published pieces that one especially likes. 

My 2020 entry has just been published, and you can find it here. It discusses a book that was recently published by the Hamilton Project, edited by Heather Boushey, Ryan Nunn, and Jay Shambaugh, and entitled Recession-Ready: Fiscal Policies to Stabilize the American Economy. You can actually download the book for free here.

If the Democrats control both houses and the presidency in 2021, it's vital, among other urgent priorities, that they enact policies like those discussed here in order to stave off the next effort at fiscal sabotage (like that which slowed the recovery in the early Obama years).