Thursday, November 26, 2020

Book recommendation for the holiday season

Especially in these pandemic / home lockdown days, I do a great deal of reading, just for my own enjoyment. Often, when time permits, I'll be reading both a fiction and a nonfiction work, so I can keep both fresh by alternating between them. My interests in the latter include history, popular science, travel, and memoirs / biographies. In the former, contemporary and world fiction, along with classics, and genre work such as murder / private eye mysteries.

In the last of these sub-categories, I've been enjoying a new find so much that I feel I ought to share it, especially insofar as my readership here includes lawyers and tax people. Sarah Caudwell's Thus Was Adonis Murdered would be a conventional mid-twentieth century English murder mystery (albeit published in 1981), a bit in the Agatha Christie style with unfolding clues, except that it's line-by-line hilarious. The first person narration, with extensive dialogue between the characters and long letters that they write to each other, seems to have stepped out of the pages of Oscar Wilde, mixed perhaps with a bit of Wodehouse.

Lawyers and tax people may enjoy its featuring a group of English barristers who are good friends and like to banter with each other. The book also prominently features a tax lawyer who is getting audited because she didn't file tax returns (she thought of the tax system as merely something she reads about in books  so she can advise clients - not as a part of real life). Now she feels that Inland Revenue is unfairly harassing her. She is always giving advice such as: find an excuse to deduct your holiday trips as business; or, if you are rich, marry someone poor so you can take maximum advantage of the income-splitting provisions. She is distressed when clients find this advice unromantic. Also (not a spoiler because it happens early), she gets arrested because, while she is on vacation, police find her inscribed copy of the Finance Act at the scene of the crime.

Just one last bit to give more of a sense of its style: the narrator, Hilary Tamor, an Oxford don who is friends with all of the barristers, is a bit of a pompous and prissy snob, given to high-toned elocution, whose gender we never learn (throughout four books in the series).

Wednesday, November 25, 2020

NYU Tax Policy Colloquium, week 13: Lilian Faulhaber's Lost in Translation: Excess Returns and the Search for Substantial Activities

Yesterday at the colloquium, Lilian Faulhaber presented the above-named paper (not posted online because it's an early draft). It has some interesting overlaps with my minimum tax article, which we discussed in the colloquium earlier in the semester, as to some extent we are looking at the same phenomena from complementary angles.

The paper traces a single idea that has spread rapidly from one source to another: the idea of enacting a minimum tax on foreign excess returns. Initially appearing as an Obama Administration budget proposal, it crossed the aisle to the House Republicans' international tax reform plans back in the day, and then in 2017 entered the law (of course, with substantial modifications from the original version) as GILTI. Meanwhile, it has also crossed the ocean and entered OECD deliberations, most recently in the still-evolving GLoBE proposal.

In all manifestations, this is a minimum tax on foreign source income (FSI), imposed by the residence jurisdiction on multinationals that have paid "too low" a rate of source country taxation, as determined either on a worldwide basis or (as in the Obama Administration versions) country by country. It's a tax on "excess returns" because, at least in most versions, it allows the exclusion of some sort of "normal" return, a term that the various versions do not define consistently, and that date back (in the international realm) to a 2013 paper by the late Harry Grubert and Rosanne Altshuler.

One of the paper's main arguments, which I found convincing, was that these various minimum taxes on foreign excess returns should be viewed as new efforts to take on the "substantial activities" issue, but via a rule in lieu of a standard. What I mean here by "substantial activities" is that, in response to profit-shifting by multinationals, typically into tax havens in which little actual economic activity is being conducted, countries have long sought to provide, by one means or another, that the shifted profits cannot exceed those that might conceivably or plausibly have been earned in the claimed source jurisdictions via actual "substantial activities" there.

Among the paper's nice contributions, even in this early draft, was its offering a taxonomy of different ways in which the notion of "extra-normal" returns - the ones that the global minimum tax might aim to reach - has been used. For example:

1) A well-known thread in the literature on income and consumption taxation posits that excluding "normal" returns - often (but not always) defined as meaning the risk-free rate of return - prevents the tax system to avoid distorting inter-temporal choices by taxpayers, in particular between current consumption and saving for future consumption.

2) Grubert and Altshuler argue that a multinational that is earning extra-normal returns may be facing lighter competitive pressures than those earning merely normal returns, offering more scope to tax them without competitive harm.

3) A familiar thread in the economics literature distinguishes rents from normal returns, arguing that the former can efficiently be taxed without thereby discouraging the activities that yield the rents.

4) Proponents of excess profits taxes often view such profits as the fruits of a "windfall" that could not have been anticipated, supporting the view that they can be taxed without worsening incentives. (The standard response is that this will discourage companies from seeking to anticipate changes that are not wholly unanticipatable.) Some arguments for a tax on foreign excess profits occupy similar territory, although they focus on concern about stable competitive distortions, rather than sudden "windfall" changes.

5) When an affiliate of a multinational company that resides in a low-tax jurisdiction, such as a tax haven, appears to be reaping extra-normal profits even though little goes on there, this may indicate that transfer pricing or other such games are going on within the multinational affiliated group.

6) If a multinational is reaping huge profits abroad, this may indicate that it has zero-basis intangible assets that are easily shifted to tax havens for profits-reporting purposes.

One thing about all these different theories is that all of them might be true, at least in particular cases. Yet they are using the distinction between normal and extra-normal profits in different ways, arguably inviting multiple and inconsistent definitions. They also quite clearly might motivate very different types of policy responses.

In sum, the paper identifies a very rich area in which a lot is going on, and a lot can be said. Here are four different directions in which the paper's further analysis might go - which is not to say either that it should cover all four, or that there aren't also various other fruitful lines of inquiry.

1) Rules versus standards - A familiar theme in the legal literature distinguishes between rules and standards. For example, a 65 mph speed limit is a rule; a requirement that one not drive unreasonably fast given all of the relevant circumstances is a standard. Both typically apply to us when we are driving on the highway. Each approach has its familiar set of pluses and minuses, and the use of each may be preferable under particular circumstances. 

The foreign excess profits taxes are generally straightforward rules, whereas requiring "substantial activities" in relation to the profits being claimed in a particular jurisdiction is very much a standard. The paper currently criticizes how the rule-like approach is being implemented in different settings, but it also reflects the view that, in this particular setting, a rule may be greatly preferable to a standard

2) Frictions, backflips, and economic substance - The question of why one would require "economic substance" in order for a particular taxpayer position to be accepted by the tax authorities is an old one. I've written about it extensively, and I've argued that the issue is distinct from rules versus standards, because one can write specific rules requiring particular indicia of economic substance.

What makes the case for economic substance requirements a bit perplexing or paradoxical is its seemingly gratuitously inducing taxpayers to incur extra deadweight loss as the price of avoiding their reach. Thus, consider the classic Knetsch case from 1960. Here the US Supreme Court held that a particular tax shelter transaction was a sham, and hence would be disregarded for tax purposes.

In Knetsch, the taxpayer purported to borrow $4 million from an insurance company at 3.5% interest, in order to "invest" the $4 million at a 2.5% interest rate. Thus, every year he was ostensibly incurring a $140,000 interest liability in order to earn $100,000. The annual return of negative $40,000 was well worth it, however, at least in the short term, if (as black-letter tax law at the time suggested), he could deduct the full $140K downside while deferring the entire $100K upside. Marginal tax rates at the time caused a $140K tax loss to reduce his annual tax liability by a lot more than $40K.

As I've noted, the "pure tax arbitrage" here makes this potentially an unlimited money machine, at least until one has wholly wiped out one's positive tax liability (since losses are nonrefundable). E.g., one can just as well borrow $4 billion, or for that matter $4 trillion, in order to "invest" the same amount with the same counter-party.

The transaction lost because, inter alia, it served no non-tax business purpose and had no pre-tax profit potential. But suppose that the upside (the $100K annual return) had been double or nothing, based on the equivalent of a coin toss. Then the business purpose would be "I'm feeling lucky," and each year there would have been a 50% chance of a pre-tax profit (albeit, also a 50% chance of losing $140K instead of just $40K).

Suppose we agree that taxpayer risk aversion makes this simple fix to the transaction unappealing. Then we are imposing a risk - for those taxpayers who do it and go forward - that they didn't want, this tax consideration aside, suggesting that it increases deadweight loss, to no good end, in those instances. The reason for imposing the requirement is that it avoids the transaction's bad consequences in cases where they give up rather than taking on board more risk. I've called this a way of imposing costlier (in lieu of cheaper) effective electivity, although the "fee" is paid in the form of deadweight loss.

This has come to be known as the "backflips" point, since in one of my writings on the topic I said that one might as well require taxpayers to perform backflips at the IRS Chief Counsel's office at midnight on New Year's Eve, as require them to add unwanted features to their business transactions. (But this was not a criticism of the approach, at least faute de mieux.)

A "substantial activities" requirement for claiming profits arose in a given jurisdiction can be viewed as requiring a backflip. It requires one to place enough actual economic activity (e.g., workers and physical assets) in the low-tax jurisdiction, even if this is otherwise suboptimal and lowers global pre-tax profitability. It also might be quite difficult for taxpayers to meet the test in a "small" or "pure" tax haven jurisdiction that doesn't have enough room to accommodate the trappings.

Optimizing in this sort of a choice environment is rather 97th-best. One wants to optimize the mix between reducing the tax planning one dislikes and increasing deadweight loss in cases where the taxpayers go forward anyway.

3) Alternative approaches to exempting normal returns - The paper discusses the wide range of approaches taken here. For example, the Grubert-Altshuler paper urges the use of expensing to exempt the normal return, but none of the prominent rules in this realm that have been proposed or adopted to date do so. Instead, they come up with differently defined exempt rates of returns that may be applied to different denominators (e.g., tangible assets, assets plus payroll, and with other variations as well).

Leaving aside the denominator question, I would think that current market rates - although there are multiple choices here - should be used. Why, for example, should the rigor of GILTI's 10% tax-free return effectively vary as prevailing market interest rates rise and fall?

GILTI also arguably shows what can go wrong when one makes the tax-exempt rate "too high." For example, suppose that a US multinational envisions that a given tangible asset will yield a marginal return no higher than 5 percent, no matter where it is placed. Locating it abroad - even, say, if this reduces the marginal return from 5 percent to 4 percent - might be well worth it after-tax, given that the asset's deemed normal return of 10 percent abroad might reduce the firm's GILTI liability.

Could a rule like GILTI use expensing to specify the exempted normal return? One virtue of this approach is that we don't need to decide what tax-free rate we want. Instead, it may come from the firm's own decisional margins. But using expensing to eliminate the tax on the normal return is not without defects. For example, it may cause tax rate differences between years to matter more, and it may create greater year-by-year swings between "income" under the excess returns minimum tax and the regular tax to which it's being compared. But the literature concerning cash-flow taxation addresses such issues and could be consulted for guidance regarding such issues.

4) Relevance of foreign taxes paid - In each of the rules that the paper addresses, the multinational's tax liability depends on (a) how one computes the extra-normal return, (b) what tax rate applies to this return, and (c) what foreign taxes have been paid. The last of these three factors raises what I call the "marginal reimbursement rate" (MRR question). To what extent does the country that is imposing the tax wish to let domestic tax liability decrease - by as much as dollar for dollar? - per extra dollar of foreign taxes paid, given that "we" don't get the money from foreign tax payments.

I've written about this issue for years, and I feel that I have gotten through to a degree. For example, the Obama Administration proposals and GILTI both provide MRRs below 100%, thus retaining some foreign tax cost-consciousness on the part of US taxpayers. But the issue isn't just whether the MRR should be below 100% - in a unilateral model where one favors national not global welfare, it clearly should - but also what sorts of tradeoffs should govern the choice. This question, I feel, has not attracted a ton of scholarly attention even though it is clearly significant.

The MRR question is among those potentially plaguing the OECD GLoBE efforts. 100% MRRs might be fine if a rule was being imposed from the top, but the OECD isn't quite in that position. Countries might also differ in what sort of MRRs they prefer. For example, a bigger country, such as Germany or France, might have different interests than a smaller one, such as Holland or Luxembourg.

Also, if countries are fine with 100% MRRs in the GLoBE setting because (for reasons of tax competition) they don't actually want the revenue anyway, that perception of their interests might have broader implications for the GLoBE's actual feasibility and evolution in the field.

Just to sum up, the paper we discussed yesterday has identified a rich mother lode of interesting issues, and I look forward to its further development.

Wednesday, November 18, 2020

NYU Tax Policy Colloquium, week 12: Abdou Nidaiye's Redistribution with Performance Pay

Yesterday at the colloquium, we discussed Redistribution With Performance Pay with Abou Ndiaye, a new NYU colleague of ours at Stern. This was a technically challenging paper for our group, not to mention its convenors, but rewarding to discuss as it relates to matters of broader intellectual interest.

The paper brings together 2 overlapping literatures, both dealing with "insurance" broadly defined. The first is the optimal income tax (OIT) literature, while the second is in labor economics and deals with performance pay.

We're in the insurance realm whenever there are choices between more fixed & more variable returns, with risk aversion giving people some preference for the former (for which they might be willing to pay in expected payoff terms, up to a point), but where problems such as moral hazard and adverse selection might 

Optimal income tax - Here the idea is to insure against ability risk, where "ability" is a stand-in for wage rate or potential earnings, rather than having any of the word's ordinary English language valence. One might also add in insuring against the risks associated with one's having under-diversified human capital (since specialization is pretty much mandatory in the labor market).

In the classic model, the government can't observe ability, but only income, which is the joint product of ability and effort (which also can't be observed). A private firm can't provide ability insurance due to adverse selection - only those with private negative information about their earnings prospects would enroll. The government can in principle solve that problem, absent significant entry and exit based on its fiscal rules, but it still has to deal with moral hazard, i.e., working less by reason of the tax. This doesn't prevent it from offering the insurance via Mirrlees' labor income tax (which ignores both investment and saving, and hence capital income, since it is a one-period model), but the government has to address moral hazard by including a significant co-pay (i.e., 1 minus the marginal tax rate).

Principal-agent in the workplace - If you're self-employed and have some sort of a business, then you're at full risk, the tax system et al aside, with regard to how much you end up earning. But suppose you work for a firm. In Coase's theory of the firm, this may reflect some sort of tradeoff in which using contracts to create command hierarchies in lieu of ongoing, flexible market interactions has a net payoff, perhaps by reason of its constraining strategic behavior in midstream between parties engaged in joint production. But this can lead to principal-agent problems, where the agent (the employee) has reason to shirk the provision of maximum effort.

Suppose the employee has purely fixed compensation. This can make the shirking problem especially bad. The firm can respond by offering performance-based compensation, where the employee does better if, e.g., sales or profits are high than if they are low. But suppose that, while effort is hard for the employer to observe, the performance output reflects both the unobserved effort level and equally unobserved good or bad luck. Then, if the employee is risk-averse, the employer has reason to offer insurance in the form of a wage that is partly performance-based and partly fixed. Just as in the public OIT setting, we have a tradeoff here between insurance value and moral hazard.

Suppose further that the employer can observe ability although not effort. Indeed, to make it simpler still, suppose for now that all of the relevant employees have the same level of ability.

To create a handy toy example, suppose that the firm's principal-agent insurance problem is optimized by telling the firm's two employees, A and B, that they will receive $80 in the event of a bad outcome, and $120 in the event of a good outcome. As it happens, A earns $80 while B earns $120.

But now, in rides the Mirrleasean income tax. Despite its being totally unneeded here - since A and B have the same ability, and also since the firm is already optimizing the tradeoff between insurance value and moral hazard - it uses a 50% income tax to fund a $50 demogrant.

Therefore, A's $80 pre-tax and transfer return is reduced to $40 by the tax, then increased to $90 by the demogrant.

B's $120 pre-tax and transfer return is reduced to $60 by the tax, then increased to $110 by the demogrant.

Given the assumptions about optimization, there is now too much insurance, given the tradeoff between insurance value and the costs of moral hazard. But not too worry, a familiar adjustment that the paper calls "crowd-out" may ride to the rescue here.

Suppose the employer now shifts the pretax payouts to $60 / $140. As again, suppose A ends up with $60 before taxes and transfers, while B ends up with $140. Now things play out as follows:

A's $60 pre-tax and transfer return is reduced to $30 by the tax, then increased to $80 by the demogrant.

B's $140 pre-tax and transfer return is reduced to $70 by the tax, then increased to $120 by the demogrant.

The firm has therefore re-optimized, undoing the harm done by the government's unneeded insurance. It's unneeded in the example because (a) there is no adverse selection issue since everyone has the same ability (known to the firm), and (b) the government has no advantages in addressing moral hazard - which, in a real world example, it might! (E.g., suppose it has discovery powers. Or, in terms of the underlying employee risk aversion, suppose it more knew about people's household circumstances, e.g., other types of income and wealth, family members, etc., that enabled it to better gauge who is likely to want how much insurance, assuming strategic behavior and transaction costs impeded firm-worker negotiations).

But actually the government has made things worse here, once we expand what we are looking at a bit. It has reduced work incentives, e.g., because A and B would still get demogrants if they quit.

The conclusion that the government should just butt out is of course not at all robust, once one pushes the hypothetical back in the direction of representing the real world. After all, ability variation, and the consequent need for ability insurance, is key to the whole OIT model. Plus, the firm can only insure against a limited range of outcome resolutions - say, high vs. low sales within its sector based on common chance factors within its experience. The risk that the firm's industry will either collapse or go ballistic in a good way may lie outside its insurance capacity, giving value to the government's capacity to ensure against human capital under-diversification risk. And there's also the issue of self-employed people who work outside of firms, unless they can find the same insurance without actually joining a firm in which they are subject to hierarchical command in cases where that's not productively optimal.

Within the model, however, we may be glad about "crowding out" - i.e., the firm's increasing pre-tax variation so as to get back to the right place despite the locally unneeded effects of the government's offering broader social insurance. One might need to know more, however, in order to judge whether the crowd-out has, say, such undesirable collateral consequences as 

This is all completely standard. It's the paper's starting point, rather than something it's asserting or testing. But one motivation for the paper is that, in the performance pay literature, although I'm not personally well-acquainted with it, there is thought to be a bit of a mystery in the form of our not observing crowd-out adjustments when tax rates change. E.g., although this alone would not be conclusive, in the last few decades we have simultaneously seen a decline in tax progressivity and an increase in at least nominally performance-based pay for high-wage employees. (I say "nominally" because, for example, CEO bonuses paid by the captive boards of publicly traded companies may play games in order to mislabel very high pay as being more performance-based than it actually is.)

The paper's main contribution is to discuss what it calls crowd-in, and which in its model pretty much full offsets crowd-out. We get crowd-in if the presence of the income tax causes the optimal deal between firms and employees to include more fixed pay, and less performance pay, than would otherwise have been example. Here's the toy illustration, just to show what's going on.

Again, recall that crowd-out changed the pre-tax and transfer compensation package from 80-120 to 60-140, so that it would still be 80-120 after-tax (leaving aside that, if employee effort declined, the wages presumably would too). So now, treating the crowd-out as Stage 1, there is a Stage 2 problem. Because of the presence of the tax, the optimal deal between the firm and the workers has shifted towards having MORE fixed pay and less performance pay than in the absence of the tax and demogrant.

Suppose that the optimal deal is now 90-110. While crowd-out, considered in isolation, would have shifted the pre-tax deal from 80-120, crowd-in shifts it all the way back to 80-120. So now we get the following, all-in so far as both sets of changes are concerned:

A's $80 pre-tax and transfer return is reduced to $40 by the tax, then increased to $90 by the demogrant.

B's $120 pre-tax and transfer return is reduced to $60 by the tax, then increased to $110 by the demogrant.

But, compared to the discussion earlier, this is now optimal, given the tax.

Again, this simple depiction of responses to the tax ignores the key idea here that the tax would lead to reduced labor supply, hence the actual deal would have to be for reduced dollar amounts. But it treats crowd-out and crowd-in as precisely offsetting - the model less exuberantly asserts that they will be largely or roughly offsetting - and hence might be used to explain empirical findings that fail to discern any crowd-out occurring when tax rates decline for the folks who are getting performance pay.

What would be the intuitive explanation for the crowd-in adjustment? The paper's current draft may not make this as clear as subsequent drafts no doubt will. But the primary explanation appears to be that, with labor effort being suppressed in all dimensions (and with substitution effects empirically outweighing income effects that might push the other way), there is simply less point to using performance pay to goose up employee effort. Less of that, and more fixed pay in response to employee risk aversion, turns out to characterize the optimal deal.

A secondary explanation, albeit not similarly relied on by the paper, might be the income effect of workers' having less $$ by reason of working less, and thereby objecting more to risk that they would have considered fine in the presence of a larger cushion. But that effect might be mitigated anyway by the use of the tax revenues, e.g., in the standard OIT set-up to fund demogrants.

If most readers of this blog are more attuned to prose than math (as I myself am), they may find the paper challenging to read. But here's hoping that this rendition of it is useful, since the ideas are worth considering and it's good to bridge the space between both the OIT and performance pay literatures, and people in different sub-fields within tax policy / public economics.

Wednesday, November 11, 2020

NYU Law School website article on my recent book event regarding Literature and Inequality

The NYU Law School website has now published a short piece describing the Zoom book event at which I discussed Literature and Inequality with Branko Milanovic, Kenji Yoshino, and the event's Zoom audience. It's available here, and includes a link to the video of the event.

NYU Tax Policy Colloquium, week 11: Owen Zidar on capital gains revenue estimating, part 2

 My prior post discussed the most important takeaways from the work that Owen Zidar presented yesterday at the NYU Tax Policy Colloquium: namely, that raising capital gains (CG) rates might raise a whole lot more revenue than official revenue estimates suggest. Here I shift to less directly consequential rumination regarding issues that the work either directly or indirectly raises:

1) Labor supply elasticity versus capital gains realization elasticity - While both labor supply and CG realizations can respond to tax rates, they involve very different types of choices. Supplying additional labor to the marketplace for additional compensation reflects an important real life choice. One typically has only a fairly limited ability to re-time it. What one chooses to do is likely to be strongly influenced by the "primitives" in one's choice framework.

Labor supply elasticity may vary sharply between groups. For example secondary earners and older workers (those nearing retirement age) have typically had far labor supply higher elasticity than other workers. Important changes over time as to these groups - and as to women's labor force participation, whether or not they are "secondary earners" in a particular household - may cause one to expect overall elasticity changes over time. So might changes in the labor market, e.g., the rise of the "gig economy" and therefore of part-time work. But absent any such things, one might have a presumption of relative stability in labor supply elasticity, because it's strongly influenced by "primitives" that one might expect to be fairly stable.

CG realization is very different. It's merely a swap between two things of presumptively equal value: an asset of some kind, and in the most typical case cash.

Why would one even bother to do this? Suppose you hold appreciated stock. Three main reasons why you might choose to sell it for its market value are (a) to get your hands on actual cash, (b) to rebalance your portfolio and/or adjust your risk exposure, and (c) because you believe it's actually worth less than the market price, hence want to get out for that while you still can.

But as Joseph Stiglitz noted in a famous, and quite prescient, 1983 article, with complete capital markets it would NEVER be necessary to sell, as a practical matter, even presuming any of the above motivations. E.g., you can borrow instead of selling, and use derivatives to adjust your risk exposure and/or to short anything that you believe is currently overvalued.

Code section 1259, first enacted in 1997, admittedly limits the extent to which you can achieve the economics of a sale without having it treated as a sale for tax purposes. But its scope is unclear, and it unambiguously permits some degree of sale economics replication - you just can't go quite all the way.

An obvious conclusion from all this is that one would be wholly unsurprised to find that CG realization elasticity was significantly higher than labor supply elasticity (as, indeed, a huge body of empirical work confirms). But also: we clearly have less of a good understanding of what drives CG realization behavior, and of how it relates to presumptively stable underlying "primitives." This may tend to weaken any premise that CG realization elasticity should generally be expected to remain stable over time. It may instead respond strongly to degrees of market completeness, how section 1259 is working, aspects of investor mood and expectation formation that we don't understand very well, etc.

This supports the conclusion that relying on past work concerning CG realization elasticity may illuminate the current world less than one would have liked. I'd tend to consider, say, 1990s work on labor supply elasticity more predictive of today's world than 1990s work on CG realization elasticity. And this in turn, to my mind, adds plausibility to the paper's finding higher CG realization elasticity than studies from decades ago had found (although the paper uses data from over a long period).

2) Ten-year estimating period - revenue estimates typically go just 10 years forward. But under the paper's model of TP behavior, this results in underestimating the revenue that would be derived from a CG rate increase. Again, a key point in the paper is that, even if I hold rather than sell today because the CG rate is high rather than low, there is still a decent likelihood of my selling the asset in the future (rather than holding it until death), even at the current rate. That prospect should be included in revenue estimates - although it's not clear how extensively the JCT does so - but even a ten-year estimate will miss it insofar as the delayed sale lies more than 10 years in the future.

Should this be taken into account? Of course it should, since it has a real present value today. And the question isn't just one of whether revenue estimates should run more than 10 years forward. Budgetary conventions should be our servants, not our masters. And a 10-year cutoff does less to distort one's vision when all years are typically the same, than when out-years systematically differ from in-years. In the latter set of cases, ad hoc adjustments can help to reduce the distortion of reality that the ten-year cutoff risks imposing on us. This has been done before in other types of cases (e.g., ignoring "off-budget" net positive current year Social Security cash flows, given the expected long-term shortfall).

3) Section 1014 (step-up in basis at death) - Replacing section 1014 with a realization at death rule for appreciated assets (along with taxing the appreciation when property is transferred by gift) would certainly be expected to raise both current CG revenues and the revenue-maximizing CG rate. It would mean that realization was always a "now or later" choice, rather than being potentially "now or never."

CG realization is also currently tax-deterred by the time value of money, which causes deferral to reduce the liability's expected present value. But with interest rates being as low as they are today, deferral isn't worth a great deal, and the timing issue becomes more like that under the "new view" of deferral in the corporate and international settings. In those settings (and that of CG realization if the interest rate is actually zero), deferral does nothing to reduce the PV of one's liability. Instead, its only advantage is to preserve the option value of awaiting a decline in the applicable tax rate.

With repeal of section 1014, legislative change would be the only remaining mechanism for delay's reducing the applicable CG tax rate. True, that is potentially a potent reason for delay, but less so than if one is certain of reducing the rate to zero, merely by holding until death.

The paper's analysis suggests, however, that section 1014 actually matters less than we had thought. If people are more frequently selling a few years down the road than we had thought, and less frequently holding until death, then "now or later" matters more than we had thought, and "now or never" less.

A further implication might be that section 1014 repeal would both raise less revenue than we had thought, and have a smaller impact than we had thought on CG realization elasticity. Not because the extra revenue disappears - but because more of it was already within our reach, even with higher rather than lower CG rates.

4) How close to the revenue-maximizing CG rate should we be? - Normally, one wouldn't want to be all that close to the peak of the Laffer curve for a particular tax instrument, because just short of the peak there is a very high ratio of marginal deadweight loss to marginal revenue.

But on the other hand, suppose one agrees with Diamond-Saez (and also Saez-Zucman) that marginal welfare weights at the very top of the income distribution should effectively be zero. Then one might be fine with applying the revenue-maximizing rate to individuals at the very top, be it with respect to CG or anything else.

This is a familiar point in the literature (whether or not one agrees with the Diamond-Saez-Zucman view) but I would add a point pertaining to the difference between labor supply and CG realization. Specifically, the deadweight loss imposed on people at the very top by high rates may have very importantly different characteristics in those two settings.

If the labor income rate on someone at the top of the distribution is too high, suppose that he or she therefore substitutes leisure for work. By contrast, if the CG rate on such an individual is too high, suppose that he or she substitutes continuing to hold appreciated assets for selling them. These two responses may have very different social welfare implications.

Substituting leisure for work might reduce the negative externalities from high-end wealth concentration. For example, as Bob Frank has noted, leisure generally isn't a positional good, whereas wealth-funded material consumption often is. So the deadweight loss (from substituting leisure for work when, taxes aside, one would not have done so) is offset to a degree by a reduction in negative externalities.

Now consider holding rather than selling one's appreciated assets, and thereby incurring deadweight loss because one wanted (all else equal) to adjust one's overall investment position. One is still just as wealthy as one was before, and it's not obvious how this would similarly involve reducing negative externalities from high-end wealth concentration.

All else equal, such thinking might support, at the top of  the distribution, a CG rate that was lower than the labor income rate even if the relevant elasticities at the same. Also, it shows why one might conceivably favor a labor income rate at the top that was above the peak of the Laffer curve (insofar as the revenue loss was offset by reducing negative externalities), but it seems less likely that one would want to do this with respect to CG realizations.

NYU Tax Policy Colloquium, week 11: Owen Zidar's "The Tax Elasticity of Capital Gains and Revenue-Maximizing Rates, part 1

Yesterday at the colloquium we discussed with Owen Zidar the above work (coauthored with Ole Agersnap), along with a preliminary draft of a short piece (coauthored with Natasha Sarin, Larry Summers, and Eric Zwick) entitled "Rethinking How We Score Capital Gains Tax Reform."

The work's main finding is that capital gains realizations are far less tax-elastic than the current conventional wisdom, including that of the Congressional Joint Committee on Taxation (JCT), has assumed. Hence, for example:

--The revenue-maximizing tax rate for capital gains lies between 33% and 47%, whereas currently it is just the sum of (a) 20%, plus (b) the 3.8% Medicare payroll tax if one is subject to it, plus (c) any state and local income tax liability that one faces with respect to capital gains.

--A 5% increase in the capital gains tax rate would raise $18 billion to $30 billion in annual revenue. By contrast, the JCT, which assumes far higher tax elasticity for capital gains and thus a far lower revenue-maximizing rate, might score this as being close to a revenue wash.

--Under plausible median assumptions, raising the capital gains high to the neighborhood of the top individual rate (under current law or pre-2017) might raise as much as $1 trillion over ten years, whereas the JCT would likely come up with a number in the ballpark of $80 billion.

This work obviously has major implications for how we might think about tax law changes that could conceivably be on the table in the next few years (especially if the Democrats win both Georgia Senate runoff elections). If accepted by the JCT it might also have a huge impact on the legislative process, given the important role that official revenue estimates can play.

The paper relies mainly on data over the last several decades concerning state-level capital gains rate changes, since there are far more of these than federal changes. But it also offers a set of reasons why JCT estimates may be systematically too low. For example:

--Capital gains that are locked in, rather than being currently realized by reason of a CG rate hike may be realized several years later, rather than being deferred until death (at which point they would disappear from the tax base given Code section 1014, the step-up in basis at death).

--The composition of capital gains has changed over time, reducing their tax elasticity. In particular, the rice of pass-throughs such as hedge funds that generate a lot of capital gain but have a business model requiring regular realization has had this effect.

--Substitution by taxpayers between generating capital gains and ordinary income means that higher CG rates may boost other tax revenue, as taxpayers shift away from taking advantage of the lower CG rate.

--Legal changes, such as the enactment of section 1259 (treating certain transactions as constructive sales) have made it less feasible and realistic for taxpayers holding appreciated assets to defer CG realization indefinitely, or even just until death.

I found the papers' empirical analysis and reasoning to be highly plausible. Note also that Zidar should have a lot of credibility on this potentially politically fraught topic - e.g., his work on high-end inequality tends to find less wealth concentration at the top than that of, say, Saez and Zucman. So, if he were to invoke the oft-abused metaphor of the umpire who merely calls the balls and strikes as he sees them, he would be far more believable than certain others who have invoked it in the past.

I'll close here, but add a follow-up post that mentions some broader conceptual issues that the work brought to mind.

Wednesday, November 04, 2020

Meanwhile, back at the ranch ...

 I did the interviews for these short clips about Trump's taxes about two weeks ago - although it seems more like a thousand years ago. Perhaps mildly amusing even if just as a diversion from everything else that's going on: