Monday, April 29, 2013

Alan Viard's "PPL: Exposing the Flaws of the Foreign Tax Credit"

About a month ago, I commented here on PPL, the U.S. Supreme Court's pending foreign tax credit case that raises the question of whether a retroactive UK tax, meant to claw back the benefits that investors derived when government-owned utilities were privatized at what turned out to be too low a price, should trigger foreign tax credits for U.S. companies.

The legal dispute reflects the fact that economically identical taxes may be creditable or not, depending on how they are formally described.  For example, if you had a $5 perpetuity and the pre-tax interest rate is 5%, so it is worth $100, a 40% "income tax" is hard to tell apart from a 2% "property tax," since either one will cost you $2 per year.  Yet only foreign "income, war profits, and excess  profits taxes" qualify for the foreign tax credit.

The IRS has raised a few eyebrows, along with a legal challenge that generated a circuit split and Supreme Court review, by taking an apparently formalistic stance here, and saying that the U.K. tax is not creditable because it was not called or expressly structured as an income tax.  More often, the IRS wants to look at economic substance, while taxpayers rest their cases on self-selected form that supports favorable tax results.

But here, saying that "substance" should control runs into the problem that the underlying law on its face rests on arbitrary and formalistic distinctions.  Should any tax that can be shown to be equivalent to an income tax be creditable, even though it's clear that some such taxes are not meant to be creditable?  If so, then how exactly is one supposed to draw the fantastical line between taxes that win due to income tax equivalence and those that lose despite it (and thus that are also equivalent to the ones that win)?

In today's Tax Notes, Alan Viard has a very nice piece exploring PPL's conundra.  Rather than argue that the case should come out one way or the other, he uses it as a vehicle to expose the fundamental problems with foreign tax creditability and the related illogic and arbitrariness of efforts to draw lines between taxes that are creditable and those that are not.  In addition to agreeing with his analysis, I'll admit to having been personally gladdened by his references to some of my recent work on foreign tax credits (to be further developed in my forthcoming book on international tax policy).  A few samples of the article's discussion include the following:

"Reiterating a point made a half century ago by Peggy Musgrave, Daniel N. Shaviro of the New York University School of Law recently emphasized that from the standpoint of American well-being, U.S. taxpayers’ foreign income tax payments are no different than their other foreign tax payments, nontax foreign business costs, and reductions in foreign income. The credit reduces American well-being by artificially and inefficiently diluting U.S. taxpayers’ incentives to minimize foreign income taxes, because those taxes can be offset by the credit. The credit prompts American companies to operate in high-tax countries, to be less zealous in challenging foreign tax assessments, and to enter transactions that reallocate other parties’ foreign income tax liabilities to them in exchange for other benefits. Statutory and regulatory restrictions on the credit cannot satisfactorily combat those incentives....

"Despite its unusual generosity, the FTC has enjoyed almost unanimous support"  [For example, to bring out the lack of coherent - or any - analysis more bluntly than Viard does, it's not classified as a tax expenditure because it's not classified as a tax expenditure.  That is to say, it has not been defined as a tax expenditure because it has been defined as not a tax expenditure.] ....

"As Shaviro has emphasized, the FTC gives U.S. taxpayers an artificial incentive to pay foreign income taxes rather than incur other taxes or nontax costs. That incentive makes no sense from the standpoint of U.S. national well-being, because there is no meaningful distinction between foreign income taxes and other foreign costs ....

"Empirical evidence recently presented by Kimberly Clausing and Shaviro confirms that a country’s provision of an FTC prompts its investors to direct their overseas investments toward high-tax countries. Clausing and Shaviro found that OECD countries with credits placed a larger share of their foreign direct investment in high-tax countries (statutory corporate tax rate above 30 percent) and a smaller share in low-tax countries (statutory rate below 15 percent) than the OECD countries that exempt overseas income or have a hybrid credit/exemption system. The difference persisted in a statistical analysis that controlled for countries’ GDP levels, geographical distance, and other relevant variables.

"As Shaviro points out, if the FTC were immediate, refundable, and completely unlimited, a U.S. taxpayer would not incur even a $1 cost to avoid a $1 billion foreign income tax liability because the taxpayer would receive a fully offsetting $1 billion reduction in its U.S. taxes. Of course, nobody actually wants the taxpayer to incur the $1 billion liability and stick the U.S. treasury with the tab, so Congress and the IRS have taken steps to prevent that type of extreme result.

"The rules are so extensive and intricate precisely because they are trying to negate the basic incentives built into the credit. Yet, they can address only the most extreme cases.... 

"Some observers object that the removal of the FTC would lead to a dramatic, and potentially undesirable, increase in the U.S. tax burden on U.S. taxpayers’ foreign-source income. As Shaviro emphasizes, however, the appropriate size of that tax burden is a separate question from the degree of relief for foreign income taxes. If taxing foreign income at ordinary rates without a credit is deemed to result in too high of a U.S. tax burden on that income, the solution is to lower the tax rate applicable to the income. Rate reduction provides relief impartially to income that has been heavily taxed abroad and income that has been lightly taxed abroad, avoiding the credit’s bias in favor of the heavily taxed income. As explained above, that bias is the source of the credit’s flaws."

To be sure, there is a distinction between the arguments that (a) unilaterally providing a foreign tax credit is bad policy [I say "unilaterally" because exemption systems effectively make foreign taxes deductible, rather than creditable], and (b) once one has a foreign tax credit and hems it in hither and yon so as to limit the resulting damage, one is likely to find coherent line-drawing impossible.  But Viard nicely shows not only that both of these propositions are true, but also that they are closely logically linked.  One cannot solve the PPL case by determining what taxes "should" be creditable given the underlying policy aims, when there is no non-circular there there.

Thursday, April 25, 2013

Tax policy colloquium, week 12: Larry Bartels' "The Class War Gets Personal: Inequality as a Political Issue in the 2012 Election"

This week, Larry Bartels presented the above paper, which relates to tax policy in the sense that it examines public views about tax progressivity, in the context of the 2012 presidential election.

Extra bonus fun: among the paper's data points was the impact of the Obama campaign's immortal "America the Beautiful" campaign ad, which depicted Romney crooning tunelessly while the words on the screen cited him for shipping jobs to Mexico and China, outsourcing other jobs to India, placing millions in a Swiss bank account, and investing in tax havens like Bermuda and the Cayman Islands.  The ad apparently had a very large impact on people right when they saw it - for example, inducing them to feel worse about equal opportunity in America and more negative about extending the Bush tax cuts for upper-income taxpayers.  But the ad's effects unsurprisingly degenerated over time (campaign ads have a short effective half-life).  Just seeing the ad again was a fond trip down memory lane for me.  Whether it mattered or not politically, it's truly an artistic masterpiece, and one could spend an entire seminar session(say, if my colloquium was "law and literature") unpacking its various levels of communication.

The paper's main focus, however, is on the following.  One natural way to view the 2012 presidential election is within a story frame of populist American responses to rising inequality that's accompanied by serious economic distress that arguably is the fault of the elite.  This is how many view the progressive and New Deal eras.  Then in 2012 we get the most anti-plutocratic presidential campaign in modern memory, with grade B Central Casting cartoon villain Mitt Romney starring in the plutocrat bad guy role.  The people rise up and endorse the Obama campaign's call for serious policy responses to rising plutocracy, including progressive tax changes.

This is a nice story, but is it true?  It's way too Frank Capra to be as convincing to the dispassionate observer as one might have liked.

In a way, this is what Bartels' paper examines.  It offers up two poster boys with alternative interpretations of the 2012 presidential election.  The first is Jonathan Chait, who said: "If there is a single plank in the Democratic platform on which Obama can claim to have won, it is taxing the rich."

The second is Kevin Hassett, who said: "I don't think the Obama victory is a policy victory ... In the end what mattered was that it was about Bain and frightening people that Romney is an evil capitalist."

Needless to say, both Chait and Hassett are playing the mandate game, because that's what people in Washington do.  Whenever you win an election, it gives you a mandate.  Whenever you lose an election, it turns out there wasn't any mandate.  Why people go to all this trouble is not entirely clear.  It's a nice talking point, but never really seems to matter much.  The Washington policy process is very substantially insulated from public sentiment.  Despite the high-minded idea that elected officials are agents of The People, broad public sentiment from the last election only matters if politicians conclude that it's stable and repeatable, and thus will drive results in the next election.  But as Harold Wilson once said, even a week is a long time in politics.  Two or four years are exponentially more so, and repeatability thus depends on inferring a long-term trend (a scenario that some Republicans appear to be at least evaluating with respect to immigration and gay marriage, but not tax progressivity).

Anyway, back to the paper.  Using survey data compiled from prospective and then actual voters during and right after the 2012 presidential campaign, Bartels finds that net support for the progressive tax changes that Obama endorsed was fairly slim and if anything narrowed during the course of the campaign.  He views this as rebutting the Chait position claiming a purposive public mandate, although one could also say that support for progressive tax changes "hardened" and "persisted."  But yes, it doesn't seem to have loomed all that large in voters' attitudes.

By contrast, a modified version of Hassett's thesis gains support from the survey data.  Where Hassett goes wrong is in suggesting (perhaps unsurprisingly for a disappointed Romney campaign adviser) that the Obama campaign was merely manipulating people by "frightening" them with a boogeyman story.  To the contrary, the public's view of Romney as a plutocrat who did not care about the interests of people outside his cadre was plain as a bell in late 2011, well before the Obama campaign started attacking him publicly.  They merely pointed to something that the public already believed. 

But "modified Hassett" still wins, in the paper's analysis.  The public responded very substantially to the view that Romney only cared about rich people, not anyone else.  Indeed, this much more deeply held version of the "evil capitalist" meme cost Romney, in the paper's best estimate, 2 to 3 percent in the popular vote.

This in turn suggests that, had there been no widespread public perception of Romney as a sneering, out-of-touch plutocrat, or if voters had not minded his being one (as indeed they might not have, in very different times), Obama's actual popular votye margin of 51.1% to 47.2% would have turned into something ranging from 49.2% to 49.1% for Romney to 50.2% to 48.1% for Romney.

I'm not sure I understand this counterfactual, in which the Republicans have a candidate with all of Romney's other perceived strengths and weaknesses (including, e.g., that he was non-ideological and a great "manager" who "understood creating jobs"), but not this weakness, even though it's arguably related closely to all of the other perceived attributes.

I also wondered why Romney does so well in this hypothetically revised version of the election, given that standard political science models based on the performance of the economy, especially over the last 6 months, tended to predict a small Obama victory.  But there may have been other factors leaning the other way.  For example, the public actually seems to have been worried about deficits and debt, and to have believed (I would say, in considerable tension with the actual campaign evidence) that Romney would have been more fiscally responsible than Obama.  So you could start from the prediction of the standard political science model, with Obama winning by a somewhat smaller margin than he did, than adjust his way for the plutocrat issue, then adjust back the other way for the issue of debt and deficits, leading to a net in which Obama wins by slightly more than expected.

But back to the points of more general interest here.  The paper suggests that revised Hassett beats Chait on the meta level as well as the direct one.  It finds that the evidence fails to support what I am calling the Frank Capra story - a fnding that I suspect might also hold if one could do a similar analysis of 1912 or the 1930s.  It finds instead that the public appears to have responded idiosyncratically at the personal level to Romney's trust deficit by reason of whom they thought he was, rather than what he was planning to do.

I tend to agree with this meta-conclusion, relative to the Frank Capra story in which an aggrieved public rises to demand serious policy responses to rising inequality and elite malfeasance.  But I was less confident that the paper actually provided strong evidence in favor of its meta-conclusion.  After all, one could imagine voter distrust of Romney the plutocrat as proxying for broader progressive views.  From the Capra perspective, why would rational voters, knowing how little in Washington politics they can actually control or even observe, nonetheless choose to focus on a particular issue, rather than on making judgments about the candidates' true characters and commitments?

In short, a U.S. voting public that attached a very high priority to addressing inequality arguably would have focused - just as the actual survey respondents did - on whose interests the candidates were inclined to serve.  The paper's meta-conclusion rests on a further assumption, which the data couldn't reach since the 2012 campaign only happened once, in which all that changes is the quirks of biography, and the public therefore doesn't reach the same conclusion about the Republican candidate even though he is the same as Romney in policy substance.

So in the end I agree with the paper's meta-conclusion because I agree with it, not because the adduced evidence seems conclusive in its favor.

Wednesday, April 24, 2013

TV appearance tonight, and the "iron box" in international tax policy

Tonight at 8:30, I'm on Al Jazeera English (Inside Story, Americas), for a 20-minute panel discussion of corporate tax avoidance.  (Mainly legal avoidance, but also with reference to illegal evasion, such as by individuals who use fake companies.)

I have no idea how I looked, as I was in a dark room in a TV studio (no monitor) while the host and other guests were elsewhere.  But these sorts of things always matter more to oneself than to others who see one.  (I am also among the countless people who don't like hearing the recorded versions of their own voices, as it sounds different from the inside.)

The overall discussion was definitely more on the side of criticizing corporate tax avoidance than one one would expect from, say, CNN or one of the networks.  But also, if my impressions as it was ongoing were accurate, a bit more in-depth than one would normally get from a TV talking heads cattle call.

The news hook for the session was the recent report that Apple is borrowing money in the U.S. to fund dividend payments and/or share repurchases, even though it has tens of billions of dollars in earnings stashed in tax havens abroad.  The reason for this wasteful transaction form, of course, is to avoid a taxable repatriation of foreign earnings.

The great thing about deferral, the aspect of U.S. international tax law that gives rise to this absurdity, is that both sides in the debate hate it.  There would be no reason for Apple to do this if we either (a) enacted a territorial system (making earnings that were reported as foreign source excludable from U.S. income even when they come home) or (b) repealed deferral while otherwise keeping our worldwide system, thus making the earnings taxable even while parked overseas.

But neither approach is particularly attractive on other grounds.  A territorial system increases the rewards to tax avoidance and profit-shifting.  A worldwide system on the current U.S. model, but without deferral, would over-tax U.S. corporate residence (relative to our market power over this attribute) and would generally eliminate U.S. companies' incentive to pay less rather than more foreign taxes.  Hence the set of dilemmas that arise when we try any marginal move within the current structure - since lessening any one distortion generally makes others worse - dubbed by me the "iron box" in my forthcoming book on U.S. international taxation.

Read my book when it comes out for a fuller account of how one could try to ease (although not entirely solve) the underlying intractable dilemmas.

Monday, April 22, 2013

Senate vote on the "Marketplace Fairness Act"

Today the Senate voted by 74 to 20 to allow the Marketplace Fairness Act to come to the Senate floor for an up-or-down vote.  This is a bill that would extend states' power to require large, technically out-of-state businesses to collect and remit sales tax on Internet sales to state residents.  The vote probably implies a significant probability that the legislation will eventually pass, as it also apparently has a high level of support in the House.

Both the Act's name, and its large margin of victory, reflect that the underlying politics here are unusual for tax-associated legislation.  Given that in-state bricks-and-mortar businesses must collect and remit sales taxes, they generally support the legislation, so that their Internet business rivals won't have a competitive advantage.  Indeed, Amazon apparently supports the Act, presumably reflecting that it already collects and remits sales taxes in much of the country anyway.

A number of Republican governors also support the legislation, as it would significantly aid their states' budgetary situations.  As we've seen more than once recently (for example, with regard to Medicaid), Republican governors, unlike members of the House and Senate, actually do have to govern, and this can positively affect their incentives and behavior.

The likes of Grover Norquist  oppose the Act (what a surprise), as do Internet businesses that want to keep the competitive advantages they currently enjoy.  Norquist and his allies like to call the Act a tax increase, but all that it actually does is improve collection of taxes that are owed under present law.  The currently tax-favored businesses argue administrative burden, but this is an age of computers, and the legislation exempts businesses with annual sales below $500,000.

The relevant prior history starts in 1967, when the Supreme Court decided, in a case called National Bellas Hess, that sales tax compliance would be too burdensome on out-of-state businesses (as well as in tension with due process doctrine at the time).  Perhaps, at the time, they were right about burden.  The opinion noted that there were more than 50,000 distinct sales tax jurisdictions in the country, including mosquito abatement districts (a detail that I have always found memorable).

Then in 1992, in a case called Quill, the Court, while agreeing that much had changed since 1967, nonetheless declined to alter the legal status quo from Bellas Hess.  Instead, it said that Congress was free to untie the states' hands under its commerce clause powers.  There may have been an element in this decision of the Justices' wanting to stay out of the political crossfire by putting the burden on someone else to actually "raise taxes" - a hesitancy that is understandable, whether or not especially judicial or commendable.

Twenty-one years is not a short time to wait for Congressional action, but better slow than never.

Thursday, April 18, 2013

Is empirical analysis really needed to debunk a foolish claim?

I am of course just an observer, not an active participant, in the debate concerning the Reinhart-Rogoff paper claiming that evil magic starts happening, in an oddly discontinuous fashion, when the debt-to-GDP ratio hits 90 percent.  It's dispiriting to read how sloppy and apparently unprofessional the paper was, and to think that it may have substantially worsened public policy outcomes around the world (although, more likely, it merely served to rationalize misguided austerity that would have been pursued anyway).  I certainly expected better from the authors.  (My fond memories of Rogoff date back to his participating in Shelby Lyman's Channel 13 broadcasts of the 1972 Fischer-Spassky championship chess match.)

But, while I certainly accept the need to take nothing for granted, and to pursue empirical inquiry wherever it leads - thus creating the theoretical possibility that the claimed results could have been confirmed, and if so, would have needed to be explained - the Reinhart-Rogoff hypothesis verges on being something that can't be true, as a logical matter.

Both public debt and GDP are artificial measures, as well as being snapshot measures.  OK, let's not worry too much about GDP, and about such conundra as Arthur Pigou's joke about the unpatriotic Frenchman who shrank the country's economy by marrying his housekeeper, thus taking her services (which she continued to render) outside of the official measure.  Public debt is also an artificial measure, as Laurence Kotlikoff has been arguing for years (although, in my view, he sometimes pushes the argument a bit too far).

For example, the U.S. has future Social Security obligations that have an expected present value and yet are not included in public debt, but that matter for the same reasons as public debt.  To wit, they might need to be paid out in the future.  Suppose we explicitly converted expected Social Security obligations into explicit public debt instruments with the same present value and payment schedule.  Then we'd have almost the same policies, but official public debt would be much higher.

Now, it's true that converting Social Security obligations into express debt would probably make them harder to renounce, meaning that the underlying policy wouldn't actually be wholly unchanged.  (This is the point that I believe Kotlikoff underappreciates.)  But the set of commitments that we actually had, and that mattered for the reasons that a debt overhang matters, would have changed far less than the official public debt measure.  So "90 percent" is just not an economically meaningful measure of anything.  It thus would be quite a surprise if significant economic consequences consistently followed around the world from changes in what is merely an artificial measure that has only a very rough relationship to the underlying set of concerns.

Then there is the snapshot point.  Reinhart and Rogoff have been rightly mocked for in effect assuming that the rise in U.S. public debt past the magical breaking point at the end of World War II led to an economic slowdown, when in fact they were observing the short-term macroeconomic consequences of rapid demobilization.  But in any rational economic world where the players have any foresight, how could a 90 percent U.S. debt-to-GDP ratio in 1945 have been the same as one in, say, 2025?  We had so vast a public debt in 1945 because we had been fighting a two-front World War that had just ended.  So it was perfectly obvious that the current U.S. fiscal policy path was about to change.  No matter how one assesses the long-term U.S. fiscal situation today, what with an aging population and concern about the growth rate of healthcare, it simply isn't comparable to that in 1945, even if we have, at a given moment, the same debt-to-GDP ratio. So it shouldn't behave the same.

I therefore rank the Reinhart-Rogoff hypothesis as not far above claims that, say, if the Redskins win their last home game in October, the Democrats are going to win the presidential election.  There simply can't be reasonable theoretical grounds for believing that it would be true.

Wednesday, April 17, 2013

Tax policy colloquium, week 11 - Sarah Lawsky's "Modeling Uncertainty in Tax Law"

Yesterday we discussed the above paper, which appeared in the Stanford Law Review recently.  (We don't entirely insist on current works in progress, so long as a paper and topic are fresh for our audience and the author to discuss.)  It concerns uncertainty aversion, aka ambiguity aversion, as distinct from risk aversion.

Ambiguity aversion can be illustrated via the Ellsberg Paradox (yes, that Daniel Ellsberg), based on lab experiments such as the following one (quoting from Lawsky's paper):

"Imagine two urns. Known Urn has 100 balls, 50 black and 50 red. Unknown Urn also has 100 balls, some red and some black, but the number of red and black balls, respectively, is unknown.

"First, Picker is told that he must bet on red, but he can choose which urn to draw from. Research shows that most people would choose to draw from Known Urn. That is, most people would prefer to bet that a red ball will be drawn from Known Urn, rather than to bet that a red ball will be drawn from Unknown Urn. If Picker prefers to draw from Known Urn, he is acting as if the probability of drawing a red ball from Known Urn is greater than the probability of drawing a red ball from Unknown Urn.

"Next, Picker is told he must bet on black. But again, he can choose which urn to draw from. And again, if Picker is like most people, he will prefer to draw from Known Urn. So Picker is acting as if the probability of drawing a black ball from Known Urn is greater than the probability of drawing a black ball from Unknown Urn."

The conclusion commonly drawn from this is that people hate uncertainty / ambiguity / second-order risk (i.e., not knowing what the probability is).  The paper takes the view that this phenomenon, which I will call ambiguity aversion (although the paper calls it uncertainty aversion), is worth adding to the "expected utility" models that researchers use to model taxpayers' behavior with regard to compliance.

Expected utility models treat the decision to comply versus cheat in tax filing as a risky financial investment.  Say I could reduce my tax bill by $100,000 by taking a very aggressive and dubious position that has only a 10% chance of being sustained if audited.  But there is only a 20% chance that I will be audited.  If I am audited and lose, suppose I will have to pay the tax, plus face a $300,000 penalty.  82% of the time, then, I save $100,000 through this strategy.  18% of the time, I lose $300,000.  Sounds like a winner, from the pure financial standpoint, unless I am very risk-averse.

It's widely believed that, given very low U.S. audit rates and also fairly low penalties (leaving aside jail time for outright fraud), the expected utility model, applied in light of evidence concerning people's manifested risk aversion in other contexts, greatly under-predicts actual compliance.  In other words, people cheat (or take very dubious positions) less than they "should" according to the model.  One could view this either as evidence of "irrationally" cautious behavior by taxpayers, given what we take to be their attitudes towards risky investment, or else as reflecting that the "arguments" typically permitted in the models - which may be limited to liking positive financial payouts and disliking negative ones, are too restrictive.  The conclusion commonly drawn is that complying or not, and being super-aggressive or not, responds not just to financial incentives but is also, to a degree, a "consumer" act.  For example, people may like being honest and socially responsible, at least if they are not angry at the government or convinced that everyone else is cheating.

OK, all that is old hat.  Lawsky's paper doesn't deny that any of that may matter, but it takes the very different tack of examining how ambiguity aversion could be added to the standard expected utility compliance model, thereby potentially increasing its degree of realism and predictive accuracy.

In effect, in her paper, the ambiguity-averse are modeled as if they were "pessimists," who acted as if, in Ellsberg's Unknown Urn, they are likely to lose whether betting on red or on black.  The paper recognizes that ambiguity aversion is not actually pessimism,which would imply lowering one's probability estimate rather than being nonplussed by one's inability to specify it.  More generally one of the difficulties in modeling ambiguity aversion is that, as soon as one converts it into a range of probabilistic estimates (e.g., "I think there's a 60% chance that I have a 40% chance to win, and a 40% chance that I have a 70% chance"), it's actually just a more refined version of standard risk, with determinate odds and payouts given one's beliefs.

The paper does a nice job of working with the problem, showing how ambiguity aversion might be modeled, and briefly discussing some possible implications - e.g., for IRS secrecy regarding its criteria for selecting audit targets, and perhaps for responding to the possibility that tax advisors, by reducing perceived ambiguity through the issuance of confident probability estimates, may encourage aggressive tax planning that has an unduly positive payoff by reason of the audit lottery  But it remains unclear to me to what extent focusing on this rather amorphous phenomenon actually produces a significant analytical payoff that would merit adding it to formal compliance models. (Which does not detract from the value of exploring and modeling it in this paper, if only to see where it might lead.)

I view ambiguity aversion, as in the Two Urns experiment, as reflecting a social instinct that, based on introspection, I surmise that people may have.  Suppose you are playing poker with people who know the odds much better than you do.  You are likely to get reamed but good in next to no time.  Or suppose the Three Card Monte guy on the street corner tries to get you to bet on red or on black in the Unknown Urn.  You are going to be rightly suspicious.

More generally, I surmise that we may frequently be inclined to really dislike acting under ambiguity or uncertainty, especially when we fear or suspect that others may have better information than we do.  And this could be hardwired emotionally, not just a rational calculation.  E.g., people may inclined to feel that they are ripe for exploitation when they know less rather than more about how to estimate the likely payoffs in a given situation, and they may feel like unhappy if they learn that they had the odds wrong, or even merely surmise this from the fact that they have lost.

What does "better information" about the odds mean in the tax setting?  For audit odds, there may actually be a frequentist probability estimate given the IRS discriminant function, yielding a determinate likelihood of audit even if you do not know what it is.  For questions of legal interpretation, it's easier to think of the underlying probability in subjectivist terms.  E.g., suppose an expert says that you are "60% likely to win" in a unique fact setting.  The issue will only arise and be resolved once.  So, rather than attempting a frequentist account, we might view this as stating odds under which the expert asserts that, if risk-neutral, he would be equally willing to bet either way.

In a frequentist setting, it's easy to say what it means to have worse rather than better information. Someone could count the marbles in the Unknown Urn, and perhaps the Picker suspects that the Asker has done so.  In the subjectivist setting, one might think instead in terms of people whom one considers better versus worse at gauging the odds.  For example, you might feel more confident about the accuracy of the stated odds if the # 1 tax lawyer in New York said that you were 60% likely to win, than if this prediction came from a college student who had a summer job at H&R Block.

Obviously, rich individuals and big corporations are highly likely to be able to get better rather than worse estimates, relative to the universe that's potentially available.  Thus, if the ambiguity parameter is significant (and potentially usable) to begin with, the well-advised appear unlikely to be its optimal targets.

Usefulness of simplifying models (re-posted due to a technical problem)

Tomorrow at the colloquium, we will be discussing Sarah Lawsky's paper, "Modeling Uncertainty in Tax Law." More on this in due course. But as the paper discusses, among other topics, the question of what makes a model useful - in particular, the tradeoff between being complete on the one hand and usable on the other - I was reminded of a favorite quote, from Lewis Carroll's Sylvie and Bruno Concluded:

“That’s another thing we’ve learned from your Nation,” said Mein Herr, “map-making. But we’ve carried it much further than you. What do you consider the largest map that would be really useful?”

“About six inches to the mile.”

“Only six inches!” exclaimed Mein Herr. “We very soon got to six yards to the mile. Then we tried a hundred yards to the mile. And then came the grandest idea of all! We actually made a map of the country, on the scale of a mile to the mile!”

“Have you used it much?” I enquired.

“It has never been spread out, yet,” said Mein Herr: “the farmers objected: they said it would cover the whole country, and shut out the sunlight! So we now use the country itself, as its own map, and I assure you it does nearly as well."

It turns out that Lawsky also knows this quote, and indeed cited it in an earlier article. (See pp. 1673-74 at n. 95.)

Silly me, I had originally thought that the full-sized map idea must be from Gullver's Travels, perhaps the visit to Laputa, but couldn't find it there via Project Gutenberg, whereupon I opened up broader inquiries and was soon set right.

Sylvie and Bruno, by the way, is a startling mixture of the sublime with the excruciating. It's richly studded with bits that anyone who loves the Alice books should find comparably delightful, mixed with sickening treacle as well as the comparatively mundane. But nonetheless a must-read for any Lewis Carroll fan (and I rate the Alice books pretty much at the pnnacle).

UPDATE: I can't resist one more Lewis Carroll quotation about maps, this time from The Hunting of the Snark:

He had bought a large map representing the sea,
Without the least vestige of land:
And the crew were much pleased when they found it to be
A map they could all understand.
“What’s the good of Mercator’s North Poles and Equators,
Tropics, Zones, and Meridian Lines?”
So the Bellman would cry: and the crew would reply
“They are merely conventional signs!
“Other maps are such shapes, with their islands and capes!
But we’ve got our brave Captain to thank:
(So the crew would protest) “that he’s bought us the best —
A perfect and absolute blank!”
This was charming, no doubt; but they shortly found out
That the Captain they trusted so well
Had only one notion for crossing the ocean,
And that was to tingle his bell.

Monday, April 15, 2013

Tax day

I use Turbo Tax, despite Intuit's reprehensible lobbying against tax simplification via the option to use "pre-populated tax returns" generated by the federal and state authorities.  I gave up on preparing my tax return by hand more than 10 years ago.

The last time I prepared my tax returns the old-fashioned way, there was a capital gains  form with 15 or 20 lines, most of them requiring a separate computation, and many of them saying something like "Take 13.7 percent of line 14 and subtract it from 81.6 percent of line 12."  (I exaggerate only slightly.)  It verged on impossible to do all of the computations without making an error somewhere, e.g., pressing the wrong button on my calculator or adding something one was supposed to subtract.  And my capital gains were trivial to begin with (both in amount at stake and in the number of transactions).  They probably all came from penny ante mutual fund realizations or some such thing.

The computations were also amazingly unintuitive.  One couldn't grasp what was going on or why.  However, probably unlike most filers, I realized that this ridiculousness was 100% the fault of Congress, not the IRS, which had been forced to implement an absurdly intricate political compromise involving multiple capital gains rates for different categories and times of year.  But this didn't make it any less annoying.

The crowning indignity that year was that I initially forgot to include one trivial item of income that was, say, $100.  Once I spotted it, I had to recompute anything in the return that was based on a percentage of adjusted gross income.  So I decided never to prepare my tax returns by hand again, and I further figured that, given the lack of anything financially or legally complicated, using Turbo Tax would be both cheaper and easier than handing everything to an accountant.

What still remains incredibly annoying, if you live in New York City, is that NYC has these two supplemental income taxes that you must file physically, on top of the NYC income tax itself.  Turbo Tax can generate the paperwork, but they aren't e-filable.

More specifically, NYC has an "unincorporated business tax," which someone once called a tax on the privilege of doing business in NYC not as a corporation.  It hits earnings that aren't employee wages - e.g., if I get a couple of hundred dollars for writing a tenure letter.  NYC also has a "metropolitan commuter transportation mobility tax," which is similar in scope (and has nothing discernible to do with either commuting or mobility).

Worse still, both of these supplemental income taxes require filing quarterly estimated taxes.  So, even if you e-file, you find yourself needing to prepare multiple mailings on April 15 or thereabouts, each arguably meriting "return receipt requested" so you can confirm that they went through.

Next question, is one of the reasons NYC does things this way so that it can add penalties to the taxes due if you aren't aware of the additional tax instruments?  I wouldn't be surprised if lots of newcomers get hit with penalties the first time around, even if they deploy Turbo Tax or an accountant when it is time to file, given the estimated tax aspect.

Saturday, April 13, 2013

Wire, "Change Becomes Us"

Wire is a cerebral art-rock-punk band that arose in England in the late 1970s and put out three great albums of constantly changing, usually high-tempo yet melodic, reflective, and off-kilter albums (Pink Flag, Chairs Missing, 154).  They then spent the next few decades periodically disappearing and reinventing themselves, including in a very 1980s electronica phase that I never quite got into (although perhaps it deserves a shot). 

They've been active again in recent years, somewhat closer to their original guitar-and-drums-based style though without trying to copy themselves.  But their latest, Change Becomes Us, is an interesting meld because it consists of songs they wrote at the end of the early period but had never recorded properly.  Peaceful, very characteristic of their old songwriting style, beautiful in a slightly harsh or stark way, and highly recommended.

Thursday, April 11, 2013

Internalities versus externalities, and the specter of paternalism

One last thought about the topic of Brian Galle's colloquium paper earlier this week.  The paper notes that there is a lot of overlap between "internality" and "externality" explanations for policy interventions such as inducing retirement saving through Social Security and employee pension rules, or addressing obesity through taxes on junk food or a "Big Gulp" ban.

What makes the two explanations overlap so much is the fact that, if people mess up badly, society may end up rescuing them at some fiscal cost to taxpayers.  In effect, if you are drowning in deep water and the lifeguard has to go out there, the fact that you are in such trouble both creates the inference that you may have erred and leads to rescue costs being borne by others.

The big exception that occurs to me is smoking.  It's arguably a bad choice most of the time, if we view smokers' testimony that they want to quit as trumping the Becker-Murphy rational addiction theory.  However, while sick smokers may get treatment at others' expense, one of the less widely known facts about smoking is that it can be fiscally advantageous to state and federal budgets.  The states collect cigarette taxes, and the feds don't have to provide years of Social Security and Medicare benefits to smokers who die relatively fast and young.

Obviously, we don't want these people to die, and encouraging smoking due to its fiscal benefits would be a sick and inhuman policy.  What's more, passive smoking by nonsmokers is a clear externality that needs to be part of the calculus, although I've heard differing estimates of how medically significant it is, outside a given household that combines smokers and non-smokers.  But the fiscal point does weaken the argument for basing anti-smoking initiatives on externalities, rather than on beneficence.

Many of the students in my colloquium class expressed distaste for regulation addressing internalities, and for the associated dirty word "paternalism."  I agree that paternalism can be odious in practice, and that our usual starting point should be to expect that a given individual, whether perfectly rational or not (and, of course, for all of us the answer is not), combines access to unique psychic information about his or her own preferences and welfare, with having the right incentive to promote said welfare.  But I nonetheless am perfectly fine with paternalist arguments for, say, Social Security forced saving, and don't require converting them first into fiscal externality arguments (although those matter as well).

What makes paternalism emotionally odious, I think, is the view that some smug individual is doing it to you, based on an unfounded superiority complex masking lofty ignorance (or even active dislike for people who are different).  Thought of that way, it's a status insult, and possibly even an aggressive rather than benevolent act.  But I think of paternalism, in appropriate cases, as something that I want to do to myself because I recognize the internal conflict between different drives and the fact that these may not always end up being resolved in the way that I reflectively prefer.

Wednesday, April 10, 2013

Tax policy colloquium, week 10: Brian Galle's “Regulation from the Inside Out: Nudges and Price Instrument Theory for Internalties and Externalities"

Yesterday at the colloquium, Brian Galle presented the above-titled paper, available (in early draft form) here.  The following is an expanded version of more cryptic notes that I had prepared for myself to help organize the discussion at the session.

Three topics. First, what is a nudge? Second, the paper’s analysis of nudges as a middle ground between subsidies & taxes. Third, internalities & the double dividend issue.

1. What is a nudge?

Paper defines them as “behaviorally informed regulation” that relies on the fact that “innocuous little speed bumps, like the nuisance of getting back up to fetch another cup of cola, or of filling out a form to start saving for retirement, can have surprising impact on individual behavior.”

But very heterogeneous:

(1) Requiring employees to opt out of, rather than opt in to, employer pension plans. (Research suggests that opt-out creates a huge increase in take-up, even though it’s easy to change the default either way.)

(2) Suppose we want more credit card use. Gas station charges $4 per gallon with credit card, $3.75 with cash. This can be described either as a “cash discount” or a “credit card fee.” People apparently hate the latter. Suppose the government bans “credit card fees” but permits “cash discounts.”

(3) Horrible picture on cigarette packages to discourage smokers (e.g., of near-death lung cancer victims. Alternatively, to encourage smoking for fiscal reasons, suppose the government required pleasant marketing photos (e.g. Bieber photos to aid in youth marketing.)

(4) Bloomberg’s proposed ban on Big Gulps, meaning that you need two trips to get 32 ounces. (This is a regulatory ban. The reason it might be considered more of a “nudge” than Social Security forced saving is that it’s easier to reverse).

SO, what are “nudges” as used in the paper or the literature?

--Not cash to/from government.

--Not a “shove,” like sending people to prison. (A 20-year jail term for armed robbery isn’t a “nudge,” because we aren’t puzzled that people might be strongly deterred by it.)

--Not a “ban” (sufficiently reversible)

--Presumably, a nudge can be either a carrot or a stick. Those are up or down from a baseline. Consider the two cigarette photos described above. Is the first one a stick, and the second one a carrot?

--Whether cash or noncash, can’t always define a given instrument as a carrot or a stick, since those descriptions are relative to a baseline. Thus, are the existing tax benefits for employee pensions a subsidy for retirement saving? Or is the rest of the income tax a penalty for non-retirement saving?

--The paper says that “a nudge is a tax.” I agree that a non-cash cost is in some ways like a cash cost (both might make the target worse-off, & prompt various types of responsive behavior). But is using one credit card framing, rather than the other, a tax? Is pension opt-out a “tax”, other than for people who want to opt out? (But in that case isn’t opt-in a tax for those who want to do that?)

Nudges aren’t defined by their attributes, but by the rationale for using them. In particular, non-cash, if a ban then there’s an easy get-around, surprisingly big response

This is going to make it very difficult to have a “unified field” analysis.

What I think we’ll have is analysis of cash vs. non-cash ways of creating cost-benefit (including Gary Becker & prison), & analysis of non-cash (perhaps cash as well?) that yields surprisingly large responses.

2. Nudges versus cash instruments

The paper’s main argument: Nudges are a middle ground between taxes (get cash) & subsidies (pay cash). Paper mainly but not entirely agrees with what I’ll call the “standard view.” Especially if raising revenue is distortionary because lump sum taxes are unavailable, then imposing non-cash costs on people often is worse than getting tax revenues, but better than paying out cash subsidies.

Consider Gary Becker on jail time vs. fines. Even if a shove rather than a nudge, say we have a choice between $1M fine & jail time disvalued by the criminal at $1M, say the behavioral consequences are the same, & ignore all other effects of jail, such as its costing money, incapacitating criminals, & either reforming or hardening them.

Under these circumstances, the fine is free money – the Treasury gets $$, everything else is the same. Better than a lump sum tax – you get revenue INSTEAD of deadweight loss (DWL).

Even if the Big Gulp ban is a nudge rather than a shove, could apply the same analysis under some assumptions. E.g., if I place a $1 disvalue having to get in line twice, why not just charge me the money? Once again, revenue instead of DWL.

Likewise, consider the horrifying cigarette photo that I disvalue at $1. Standard view notes that this is the same as Becker absent other differences.

One might also have the case of getting the same DWL either way, with or without revenue. Then a pollution tax is like a nudge plus a lump sum tax.

Finally, consider applying the standard view & subsidies. Say we can get the same behavior either by $100B/year in pension tax benefits or by changing the default. Nice to avoid the $100B handout that would need to be reversed through distortionary taxes.

OK, so what could be wrong with the standard view? To be discussed further at the session, but some initial points include the following:

(1) If the whole point is surprisingly high response, nudges may reduce not just revenue but also DWL. E.g., suppose that the Big Gulp tax would have high collection costs/ If a trivial nudge gets the same behavioral change & thus the same benefit, it reduces both revenues and DWL – possibly permitting use of a more efficient instrument.

Note also that big response may complicate the idea of utility deduced from preference satisfaction.

(2) Where surprisingly high response, we may question whether distributional effects are actually the same. E.g., hit smokers with a $1 tax or a horrible photo that gets the same behavior. Does this mean they stably disvalue it at $1? And even if so, the fact that it’s non-market rather than a cash cost means it won’t affect their ability to afford market goods.

One last point concerns income effects. The paper says we may want to give $$ to people who at the margin are producing positive externalities, take it away from those producing negative ones. But this only matters if we haven’t gotten the incentives right.

(3) Everyone knows there is more to the story. E.g., in the Becker example, incapacitation & reforming people in prison would be relevant. But this is context-specific, & it’s hard to generalize about nudges writ large.

(4) One of the biggest issues is targeting.  The "libertarian paternalism" argument that one can ignore the nudge and still get what one wants sounds backwards from a conventional tax policy perspective, as we want to raise revenue rather than lead people to incur deadweight loss by avoiding the tax.  But there can be a screening effect.  Consider two groups of people: Those whom we want to influence with the nudge (e.g., say it's about internalities), and those whom we will in fact influence because they don't opt out.  The greater the overlap between these two groups, and the less the overlap between the people who would pay the cash tax and the behavior that we'd want to discourage, the more attractive it may be to use the nudge instead of the cash instrument.  But the presence or absence of this effect presumably will always be context-specific, and it's unclear how one can generalize about it.

3. Internalities and the double dividend

Paper suggests that internalities may be very different than externalities. E.g., no double dividend problem with addressing them through tax instruments. Not sure I agree. But we need to define both internalities and the double dividend hypothesis.

Internality: per the paper, the only difference between it & a negative externality is who is being harmed. Instead of other people, it’s one’s own future self. Suppose the problem is hyperbolic discounting. You undervalue the harm to your future self when you drink Big Gulps or smoke cigarettes or don’t save for your own retirement. Yet yesterday you would have wanted to choose properly between today and the future.

Internalities differ from externalities in that, for them to matter, they require departing from a rational choice framework. Whereas externalities could be examined purely within such a framework. But when we use nudges to address externalities, we have likewise departed from that framework.

So, it’s not obvious to me that internalities & externalities should function as differently as Brian suggests. Either way, someone’s welfare is being ignored in the decision-maker’s calculus, & we’re trying to exploit individual irrationalities or discontinuities.

OK, on to the double dividend hypothesis. Say we have a carbon tax. We improve incentives AND raise revenue. Since the latter usually requires DWL, we’re doubly blessed. Does this suggest that, in today’s U.S. economy we can layer a carbon tax on top of the existing income tax and not discourage economic growth, etc.? (In the steady state – this is not about Keynes and the business cycle.)

If you have no taxes, need revenue, & can choose a Pigovian tax in lieu of enacting something distortionary, clearly a double dividend. So what’s missing?

Let’s switch subjects & then circle back. Optimal commodity tax literature, inverse elasticity rule. It turns out that if you are taxing all commodities except leisure, meaning that you have an “income” tax (no time in this model, so it’s the same as a consumption tax or a wage tax), and if you grant an assumption called separability of work & leisure in people’s utility functions, there is nothing to gain from commodity tax differentiation EXCEPT for leisure complements vs. work complements.

To offset work discouragement, you may want to raise the tax on leisure complements, lower it on work complements), thus reducing the work-leisure problem, albeit at the price of distorting commodity choice.

An example: tax food that’s cooked at home (leisure complement, since you have the time), subsidize restaurant food (work complement). Of course, that’s the reverse of what real world RSTs do.

OK, suppose we grant that not having a carbon tax is effectively a work subsidy (like exempting work complements). The same line of argument suggests that this is partly a good thing in efficiency terms.

Now we create a carbon tax at the right level. It’s a Pigouvian tax that improves incentives at that margin, but it also raises the tax rate on work. So that reduces efficiency. Still worth doing, but no longer free money in efficiency or economic growth terms.

What does this mean for internalities? Take the Big Gulp rule. In a rational choice scenario, the ban on Big Gulps does indeed make work (earning $$ to buy a 16 oz drink) less valuable. Unless we think the key is whether you have time for extra waiting on line, in which case it might be hitting leisure.

But why would the labor supply effects on you depend on whether our rationale is based on the internality or the externality? What matters is the relationship between the work-leisure choice and the item that’s being addressed.

Likewise, suppose we wanted to nudge people towards eating in restaurants more. Because that also happens to be a work complement, it would be double dividend plus.

Now suppose instead that we want to nudge them towards eating at home more. Then we would be facing the problem of increased work discouragement.

But either way, it wouldn’t depend on whether the nudge was motivated by an internality or an externality.

OK, if we weaken consistent rational choice, all bets are off. Now the key is how it plays through perception regarding work-leisure choices. But while this creates an imponderable, it’s still not about externality vs. internality as such.

SO: Is there a general link between internalities and double dividends? Or does it depend on other stuff, both for externalities and internalities?

Monday, April 08, 2013

Forthcoming short "jot"

There is an interesting new website called Jotwell, which stands for the "Journal of Things We Like (Lots)."  The basic idea is to recruit a bunch of editors in a given legal field, such as tax, each of whom agrees to submit a short piece (500 to 1,000 words) once a year discussing a recent publication - two years old or less - that he or she particularly likes.

The chief aim is to direct readers' attention to good things that they might otherwise have overlooked.  (As we all know in the "biz," there's a tendency for way too much written and none of it to be read by anyone.)  Secondarily, one could think of it as a nice corrective to the weakness of prevailing professional incentives to express appreciation for others' work.  Often, the reason for mentioning prior work is just to criticize it (or else to unselectively footnote-bomb the prior literature so that prior authors don't whine and the law review editors are happy).  While astute criticism may be a precondition for intellectual progress, perhaps the overall balance is skewed.  Third, there can be a benign conspiracy of the under-appreciated to say publicly about each other what they are unable to say about themselves.

Anyway, I agreed to participate as a Jotwell tax editor, even though I admit that I can sometimes be hard to please.  I've submitted my first Jotwell review, and will post the link when it's up (probably in May or June).  The subject, not strictly a tax piece but pertaining to global finance, trade, and macroeconomic policy, is Benn Steil's excellent and entertaining new book, "The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order."

Wednesday, April 03, 2013

The pension "default" issue, and income vs. consumption taxation

A discussion at NYU Law School of a draft paper by colleagues on behavioral economics, plus the fact that Brian Galle's paper at the colloquium next week will be on the topic of "nudges," pushed me to an I hope moderately interesting thought about retirement policy through the tax code that I thought I would mention here.
Recent empirical findings, from a number of papers by leading researchers, suggest that employees' participation rates in employers' pension plans are enormously sensitive to the default setting.  That is, if they are automatically enrolled and would need to opt out, they participate at far higher rates than if they need to enroll by specifically approving in advance regular paycheck deductions to fund program participation.  This arguably undercuts viewing their decisions as rationally responding to consistent preferences about present versus future consumption, the tax planning issues, etcetera, since opting in or out is fairly easy to do, and thus seems verging on trivial relative to the significance of the choice on how one ends up.

Now, there are possibly "rational" expectations within conventional economics for this, at least under bounded rationality with limited information and time.  E.g., perhaps employees who are enormously responsive to the default setting regard it as a statement, by someone who is knowledgeable and has their best interests at heart, regarding what they most likely should do, etc.  I don't find this line of rationalization very persuasive, but suppose we conclude that greater participation is a good thing, whether people voluntarily choose it or not from either setting.  This could either be based on the notion that they will otherwise mistakenly under-save, or it could even reflect an externalities problem (they rationally under-save on this view that this will cause them to be treated more generously than others when they retire).

But for now, let's just suppose we accept the following propositions.  First, making pension contributions the default setting, and thus requiring employees to opt out if they'd rather get cash today, has much bigger behavioral effects than giving tax benefits to retirement setting.  Second, this makes both them and everyone else better-off.  Third, we could change the default, repeal the tax benefits for pension contributions, and get more retirement saving while also saving $100 billion per year, from the budgetary effects of repealing the tax benefits.

Deliberately overstating the claim in order to make it clearer, one could argue the following.  People are so inattentive that the tax benefits for retirement saving are like a lump sum subsidy (i.e., a lump sum tax with the sign reversed).  So there is simply no need for the subsidy if we change the default rule instead.

This admittedly is overstated unless one has quite a radical critique of the extent to which people focus on the actual long-term after-tax consequences of their labor supply decisions.  But there is an element of this claim even in more modest versions of it, which admittedly appear to receive significant empirical support.

OK, onto the punchline I want to add here, which I believe is more novel than anything said here so far.  Suppose initially that one sufficiently agreed with the above claim to support repealing pension tax benefits and relying on the replacement of opt-in with opt-out to produce high participation levels.  Now suppose that one also favored switching from an income tax to a consumption tax, based in part on the view that, outside the employee pension setting, people generally ARE deciding how much to save based in part on its tax treatment.  (Saving for future consumption is disfavored by an income tax relative to immediate consumption, whereas a consumption tax is neutral if the same tax rate applies in all years.)

Then one arguably should at least consider supporting a consumption tax in which employee pensions, unlike all other saving, actually ARE taxed under an income tax-like approach.  After all, it's still (by hypothesis) a lump sum tax, and the fact that you've changed the tax system's baseline approach to saving outside the employer retirement plan context arguably doesn't matter.

I don't quite mean this (i.e., enactment of a consumption tax is accompanied by distinctively applying unfavorable income tax treatment to retirement saving through work) as a serious proposition.  But it does help illustrate how conventional modes of tax policy thinking become less certain once one starts incorporating behavioral economics evidence and reasoning.

Tax policy colloquium, week 9: Alan Viard's "Progressive Consumption Taxation: The Choice of Tax Design"

Yesterday at the colloquium, we discussed Alan Viard's above-titled draft paper, which is a follow-up to his excellent book (co-authored with Robert Carroll), Progressive Consumption Taxation: The X-Tax Revisited.  But whereas the book focused in depth on how one should design an X-tax, if it were used to supplant the existintg income tax, the article is a comparative assessment of the X-tax versus the other main instrument for progressive consumption taxation, a personal expenditure tax or PET.

The X-tax would replace the individual and corporate income taxes (and potentially other taxes as well) with what is basically a VAT collected from all businesses, modified to include firm-level wage deductions and matching individual tax returns on which the same wages were included.  The idea is to add progressivity, which is missing from a VAT, by applying progressive rates (rising in stages from zero to the full business rate) via the wages.  So it's equivalent to a VAT plus a net wage subsidy that, in effect, partly and progressively rebates the VAT for workers, to the extent that they have income in lower brackets.

The PET would replace the same set of taxes with a levy on individuals that would look a bit like a conventional income tax, only with unlimited IRA-type deductions.  More specifically, all saving and investment would be deductible (and expensed) - most likely, as an administrative matter, through the use of "qualified accounts" that would help keep track of the dollars involved.  All withdrawals from the accounts would be added to income, as would loan proceeds (though these would be re-deducted if used to fund saving and investment).  To some eyes, taxing loan proceeds may look a bit odd, but of course a retail sales tax, just like the PET, reaches loan proceeds that one spent on consumption rather than adding to one's gross savings.

This is a topic that I know fairly well, and it has a pleasant personal association for me (wholly without regard to any policy merits or demerits) given the association of both with the great David Bradford, who was my colloquium co-convener for almost 10 years.  David (with the U.S. Treasury Tax Policy straff) spearheaded a classic 1980s study of a PET prototype called the Blueprints cash-flow tax, and he also developed the X-tax (which was based on the Hall-Rabushka flat tax but added greater progressivity).

I believe that Bradford's main rationale for shifting from the PET to the X-tax was optical: he felt that having part of the tax collected at the business level was politically necessary.  But there may also be an offsetting optical advantage to the PET, which is that the likes of Mitt Romney and Warren Buffett are visibly taxpayers under it even if they don't have current year wages.  (This is just an optical concern if one believes they are bearing, as consumers, the business-level tax on their purchases at the maximum rate, and that those paying the individual-level wage tax are actually getting a net subsidy on their wages.)  More on the optical issues at the end of this post.

I've never come to closure on which I would prefer as between the PET and the X-tax.  Making this less urgent is the fact that I don't expect either to happen.  Viard's paper at the colloquium yesterday usefully illuminated the tradeoffs that one should think about.  Pertinent aspects include the following:

--Both systems, like the current income tax, have an "averaging" problem.  That is, under consumption tax (lifetime-based) reasoning in particular, it may be undesirable to have the graduated marginal rates, applied on an annual basis, impose higher taxes over time on people who have up-and-down rather than smooth annual taxable amounts.  It's possible that the problem under the X-tax is worse in the absence of an averaging mechanism (if wages vary more on an annual basis than does consumption), yet it also might in practice be easier to solve.  David Bradford's Blueprints cash flow tax had a very clever mechanism to let people self-average under the PET, but it may have required greater awareness of the needed manipulations than one could realistically expect from most people with busy lives.  But I wonder if computers could solve this at some point (in effect, if everyone used a Turbo Tax-type program with full but secure on-line access to one's own prior years' return info).

--I would argue that the PET is more compatible with very steep high-end tax rates, if one favors them to address rising wealth inequality at the top.  Under the PET, you limit those rates to the very high end.  Under the X-tax, you more or less have to make the business tax rate equal the top individual rate, so businesses below the plutocratic level (on an individual owner basis) would need to go through the two-step of nominally paying out all the net cash flow as salary in order to get it into the lower rate brackets.  This might be a nuisance and be under-utilized by people who didn't understand how it worked, even though it is just a paper transaction (you can "pay" yourself a high salary for tax purposes and then reinvest the funds tax-free).

--Income and/or assets would still be used, under either proposal, to determine what needs-based benefits people got (TANF, Food Stamps, Medicaid, etc.).  This is interestingly in possible tension with the usual consumption tax approach that current assets, if not spent on consumption are irrelevant (e.g., because we will tax their use in consumption in future years).  One could view this reliance on assets or income either as contradicting the basic consumption tax philosophy or merely as responding to the adjustability of current year consumption or wages if, in effect, low wage/consumption levels would otherwise have a high implicit tax rate via the phaseout of transfers.

--Otherwise, the main virtues and vices of the PET, relative to the X-tax, come from its making greater use of the individual-level return.  Whether for good or ill, tax expenditures may be easier to provide (including to non-wage-earning rich people such as Romney and Buffett) in the PET than in the X-tax, at least if refundable credits are politically costly since they look more like "spending."  This point might alter the current partisan politics of refundable credits.  Household-based adjustments also are easier to make universally via the PET, if costly to do otherwise.  (By this I refer to the treatment of marital or couple status and of children.)

--The main virtues and vices of the X-tax, relative to the PET, come from its using the business level.  Optics aside, this is often a convenient place to collect tax revenues.  The Viard-Carroll book suggests that one defect is the need to police over-payment of wages to owner-employees or others.  E.g., a partnership pays its partners more than the value of their services, so as to max out on the lower rate brackets.  But I believe this probably isn't a problem outside of the household setting (e.g., I have my firm pay my spouse and kids big salaries, even though they are not doing significant work so we can multiply our use of the lower brackets).  Why not give true owners the full benefit of the lower rates, and presumably they won't want to overpay true third parties (leaving aside the personal vs. business problem, e.g., I pay for a meal and pretend it's to an employee for business services, that we already face under the existing income tax).

--A key dilemma under the X-tax is whether the business-level tax should be origin-basis or destination-basis.  All existing income taxes are origin-basis, which means that you include amounts received from foreigners for exports, and can deduct or capitalize amounts paid to foreigners for imports.  All existing VATs are destination-basis, aka border-adjusted, which means you wholly ignore cash flows to or from foreigners.  The horrible thing about origin basis is that it requires transfer pricing for the operations of multinational firms.  Hence, most experts prefer destination basis for the X-tax.  However, Carroll and Viard (along with David Bradford) prefer the origin basis, despite the transfer pricing problem, because of the transition wealth effect on Americans vs. foreigners of switching to a destination basis tax.  In their book, for reasons that are logically compelling but too complicated to explain here, they estimate that straight-out replacement of the existing income tax with an X-tax that used the destination basis might transfer almost $9 trillion from Americans to foreigners in the transition, although one could try to mitigate this by applying transition rules.  However one comes out, all can agree that it is going to be suboptimal either way.

The PET would also be effectively destination-basis, as it taxes national consumption rather than production, even though it doesn't have special rules for cash transactions with foreigners.  So that is a bad thing if you don't like the one-time wealth transfer, but at least it is a good thing if you hate transfer pricing.

--A final issue raised by Viard's article is: What about a hybrid?  That is, instead of having just an X-tax or PET, why not have both - say, at half the tax rates for each that you would have chosen in the standalone setting.  This may initially seem to be Herman Cain-style silliness, a la thinking that 9-9-9 is better than 27 if the taxes are actually in some general sense all the same.  But insofar as implementation problems with the X-tax and the PET cause them to create distinctive distortions (or fraud / tax planning / under-collection risks), using some of each not only diversifies the collection risks that the federal government faces, but might also reduce those distortions (which would be expected to rise faster than ratably with the tax rate).  Plus, you get to address both optical problems - there's a business level tax, and Romney / Buffett are taxpayers.