Only at NYU Law School

Perhaps I can be forgiven for a spasm of institutional chauvinism.  There is no place like NYU Law School, in the U.S. or indeed around the world, for studying tax law and policy.  A case in point today came from an event that was organized pretty much on the fly, yet drew a strong audience response.

Professor Alfons Weichenrieder of the Economics Department at Goethe University in Frankfurt is a leading researcher in the field of international taxation.  Like several other excellent economists in this field in both the U.S. and Europe, he is interested in understanding the institutional details of how countries' tax systems work, recognizing that one can't otherwise do good empirical research about international taxation.  In addition, like some but not all of the economists whom I have met, he is interested in talking to lawyers.

He was in the U.S. for a conference that we both attended last Friday, and had asked me if, while in the area, he could present a paper at NYU Law School.  We thought that this would be great, the only question being whether we'd be able to deliver a proper audience, but we figured we'd do our best.

The event took place from 6 to 7 pm today.  He presented his paper (co-authored by Martin Ruf) "CFC Legislation, Passive Assets, and the Impact of the ECJ's Cadbury Schweppes Decision."  The background here is that in 2006, in the Cadbury Schweppes decision, the European Court of Justice, on grounds that many fair-minded people find considerably short of being persuasive, held that the U.K. could not use its controlled foreign corporation (CFC) rules to combat tax planning games that placed passive income (via foreign subsidiaries of a U.K. company) in low-tax Ireland, rather than high-tax England, unless the taxpayer was making use of a "wholly artificial" arrangement.

The decision undermined EU countries' ability to address income-shifting games through the use of subsidiaries in low-tax members of the EU.  A number of EU countries, I believe including Germany, responded to the Cadbury Schweppes decision by loosening their CFC rules in the interest of advance compliance.

Using a unique data set concerning German companies, the Weichenrieder-Ruf paper examines the question of whether there are empirical traces suggesting that German companies responded to the new opportunities afforded.  Although the response appears not to have been huge - in part, perhaps, because of uncertainty regarding how aggressively Germany would push on the decision's permitting the disallowance of tax benefits from "wholly artificial" arrangements - there nonetheless are discernible signs that companies responded by holding more passive assets through EU subsidiaries, albeit less through subsidiaries in outside tax havens such as the Cayman Islands.

OK, onto the NYU Law School chauvinism.  One point is simply that we had an event like this, and have many such in the course of a typical semester.  But another point is that, despite a late start on our part in promoting the event (basically because everyone is every busy), we got more than 20 people to show up (and then engage in lively discussion), on short notice, on a Thursday night from 6 to 7 pm, with no food available (other than a Cadbury chocolate bar that Alfons whimsically brought), on a rather specialized topic, for an empirical paper by an economist who is not from the U.S. and thus is not known to most people here, and on a night when many or even most of the tax students who might have come were unavailable because they were going to Washington for a job fair.  The audience included NYU students, NYU faculty, and tax people from outside the institution who are regularly participating members of our broader community.

I tend to doubt that all this could have happened at any other U.S. law school.

NYU Tax Policy Colloquium, week 6: Hines and Logue, Delegating Tax

Yesterday at the NYU Tax Policy Colloquium, Jim Hines and Kyle Logue presented their paper, “DelegatingTax.”  The paper’s main arguments are: (1) Congress does less delegation of lawmaking authority in tax than in other areas of law, such as environmental regulation, (2) the grounds for favoring significant delegation in other areas also apply to tax, and therefore (3) it might be desirable for Congress to increase the degree to which it delegates lawmaking authority in the tax area.

Possible examples of greater delegation that the paper discusses include (a) giving the Fed authority to make tax rate changes for countercyclical reasons, (b) giving greater discretion, with regard to the design of tax preferences either to the Treasury or to subject-matter experts, and (c) empowering a commission, a la the military base-closing commission of some years back, with the authority to make broad determinations with regard to which tax preferences might be eliminated to fund either lower rates (in a 1986-style reform) or else long-term deficit reduction.

This was an interesting paper and I am generally sympathetic to its line of argument.  To be sure, it is hard to pin down what exactly one means by greater versus lesser delegation (although there clearly is some underlying content there).  Moreover, if it could be defined crisply enough, one might want to try to examine empirically the relative delegation in tax versus other areas in the U.S., and as between the U.S. and other countries.

Further thoughts that I had upon reading the paper are contained in the following, which is an expanded and reorganized version of notes that I prepared for myself in order to be ready for the session:

1) What do we mean by delegation of tax lawmaking authority, and where do we tend to find it?

(a) It has something to do with the choice between rules and standards, where the latter might be viewed as involving greater delegation, but is not exactly the same thing.  (E.g., one could delegate either more or less under either a rules-based or a standards-based approach.)

(b) If we are talking about tax delegation, we should keep in mind delegation to the courts, not just to the Treasury Department.  Most judicial decisions on tax in the U.S. involve statutory interpretation, and thus not only could be overturned by Congress ex post, but in many cases could have been headed off ex ante if Congress had wanted to specify more precisely what it meant.  (Often it doesn’t, however – apparently preferring to delegate.)

(c) Congress appears highly inclined to delegate in cases where it is applying very broad legal concepts that have murky or unclear underlying economic content.  Examples include:

            (i) Section 482, which authorizes the Treasury to reallocate taxable income between related parties based on the principles of clear reflection of income and preventing evasion.  Under the regulations, this is generally done under an “arm’s length” standard.  One asks the counterfactual question: “What would the related parties have done if acting at arm’s length?” and tries as best as one can to finesse the problem that this question commonly lacks a coherent, much less discernible, answer.  My point here is not that doing this is a bad idea (not doing it would probably be even worse), but that the difficulty of devising workable principles has apparently induced Congress to punt / delegate.

            (ii) Debt versus equity – This is the re-delegation that failed.  As is well-known, there is no coherent basis on which the tax law can distinguish debt from equity, at least in close or mixed cases, and there also is no particular policy reason for treating them so distinctively.  Congress for decades delegated the whole issue to the courts.  However, in 1969, it passed Code section 385,  instructing the Treasury to issue regulations sorting out the mess.  The Treasury tried for a while, issuing two sets of proposed regulations (if I recall correctly) that it then decided not to finalize.  So delegating / punting the issue to the courts remained the prevailing norm.

            (iii) Economic substance requirement – Case law has long held that tax-motivated transactions will be ineffective if they lack requisite economic substance and/or business purpose.  This is of course a “standard” developed by the courts and for decades left alone by Congress.  When Congress finally codified the economic substance approach, for use in applying penalties, it bent over backwards to make clear that it was not adjusting or revising the prior common law approach in any way, apart from one distinct matter: it provided that taxpayers must meet both the “objective” and “subjective” aspects of the prevailing test, whereas case law had been divided as to whether one needed to satisfy both, or just either one.

2) Is there less tax delegation, and if so why?

(a) Presumably, Congress will only delegate lawmaking authority (or delegate “more” rather than “less” when it realistically has the choice) where the relevant decision-makers conclude that the political benefits of doing so exceed the political costs.

Making a consequential political decision often has both political benefits and costs.  One gets the credit but also the blame; one pleases the winners but also angers the losers.  Given, however, that politicians both often like to exercise power and benefit from doing so (e.g., reputationally and in fundraising), presumably “extra” delegation that was not practically necessary tends to reflect some particular motivation.

Here are 3 representative examples:

            (i) Public interest reasons for delegating: If, say, an independent agency can actually do a demonstrably better job than Congress, and members of Congress believe that on the whole this will be to their political benefit, they may delegate for entirely “good” reasons.  A classic example is delegation of power over monetary policy to the Fed.  (Admittedly, this example risks becoming obsolete in the era of Rand Paul.  I suspect that, if were necessary to pass new legislation retaining the Fed’s current authority over monetary policy, it would fail in the House and be filibustered in the Senate.)

            (ii) Symbolic politics: Here an example is the creation of the Environmental Protection Agency (EPA).  To be clear, I certainly agree that the creation of the EPA was important substantive policymaking, with real effects that I believe were on the whole decidedly good. But to legislators at the time, I would think that it had an important symbolic element: By creating a new agency, one takes the credit for “doing something” about environmental concerns.  But since the EPA is the party actually making decisions that involve tough tradeoffs (or winners versus losers), it gets the blame on the implementation end.

            (iii) Prisoner’s dilemma: Suppose there is broad consensus that we all lose overall from an array of parochial benefits.  But no one wants to give up his or her narrow benefit, unless enough others are doing the same.  Congress’s creation of a military base-closing commission (with Congress to vote the final recommendations up or down, with no amendments permitted) is a classic example.

(b) In practice, agreement to delegation appears to require broad underlying consensus regarding the general policy approach that Congress   However, while broad delegation’s reliance on the existence of underlying consensus appears clear empirically (at least based on casual observation), it is less clear why, as a theoretical matter, this should be so.  One could, for example, imagine political players who strenuously disagree but are mutually uncertain of success handing things over to an arbiter.  But my impression is that this doesn’t generally happen.

(c) The conditions for broad delegation are generally missing in current tax politics.  Politicians appear not to view the political benefit as exceeding the political cost, and an important reason is the lack of underlying consensus.  With respect to particular examples:

            (i) The Fed and tax rates – Even when there was greater consensus than we have today regarding countercyclical fiscal and monetary policy, why would Congress hand over tax rate authority to the Fed?  Isn’t it more fun to get the credit oneself for cutting taxes during recessions?  And while Congress could reasonably have anticipated that it would be less eager to clamp down when there was inflation risk, at least the Fed was still there as a backstop via monetary policy.

            (ii) Design of tax preferences – Here is where one could most readily imagine it happening.  Indeed, there are a couple of small areas in the law (e.g., with regard to low-income housing credits and state agencies) where delegation has indeed expanded a bit.

            (iii) Repealing tax preferences to fund a rate cut or reduce the fiscal gap – This would be just like military base-closing if there were sufficient underlying consensus, along with willingness to lose one’s own favored items so long as others shared in the haircut.  But there simply is no such underlying consensus. What is more, many of the underlying items are just too big for their proponents to be philosophical about losing them even if lots of other stuff is nicked as well.

3) Would more tax delegation be beneficial?

(a) Analogy between delegation to an independent agency and the existence of nonprofit firms – There is a rich law and economics literature concerning when and where we observe the use of nonprofit firms – for example, in charity work, higher education, and the fine arts.  The dominant account, for example from Henry Hansmann’s work, emphasizes that it is a response to the concern (by consumers and/or donors) that here, unlike in many other areas, the standard profit motive would be over-powered and partly misdirected.

Hansmann emphasizes, for example, the role of ambiguous outputs (e.g., higher educational quality, which may be hard to observe, apparently leading to the surmise that tamping down the profit motive may lead to better results.  In a very small piece that I once wrote in this area, I made the additional point that the substitute motivation is somewhat of a black box, which we fill in based on our empirical beliefs concerning the motivations and utility functions of likely nonprofit actors.  This may be why, for example, we don’t observe nonprofit auto repair shops.  Their being nonprofit might mitigate concern that they were using asymmetric information to fool us into overpaying for stuff we don’t need, but there is no theory of altruistically minded nonprofit auto repair workers who would love and respect the process as much as we academics try to respect effective teaching and good scholarship.

Substitute direct political accountability for the profit motive, and independent experts or professionals for nonprofit actors in a charity, and you get a parallel scenario analytically.

(b) Analogy to the Financial Accounting Standards Board (FASB) and the specification of generally accepted accounting principles (GAAP) – Suppose Congress instructed the Treasury to define taxable income, basing it on economic income but subject to reasonable administrative concerns, including use of the realization requirement where Treasury thought it appropriate.  Full stop, subject only to whatever provision Congress separately made for the design and use of tax preferences.

Would this be a good thing?  I am inclined to think so if the Treasury in turn delegated the task to an insulated professional agency.  But admittedly this is just a surmise – if Congress did this (which it won’t), then we would find out how well or poorly it worked.

One reason for thinking that it might be a good thing (leaving aside that it will never happen) is the analogy to FASB and GAAP.  FASB is a somewhat independent and politically insulated agency under the itself-somewhat-independent Securities and Exchange Commission, and it uses its GAAP rules to define financial accounting income.

Most accountants whom I know – and there also are arguably supportive empirical studies – believe that GAAP, financial reporting, and the quality of the information provided to investors by reported earnings would be a lot worse if Congress meddled a lot more than it does in the process.  On the few occasions when Congress has intervened (e.g., when Senator Lieberman, in the late 1990s, successfully bullied them into dropping plans for treating executive stock options as deductible), there is a view that generally or typically it has made things worse.

This naturally inclines one to speculate that similar delegation with respect to defining taxable income would likely be a good thing, if it was done right.  But obviously we don’t know for sure, and an experiment permitting us to find out remains highly unlikely.  I could only see it happening if the U.S. federal income tax became far less important and prominent than it is today (e.g., as tariffs were once a central concern of Congressional policymaking and then ceased to be such).

Talk on my international tax book at Duke Law School

Last Wednesday (February 26), I  gave a talk at the Duke Law School's Tax Policy Colloquium concerning my newly published book, Fixing U.S. International Taxation.

My slides, which aim to present an overview of the book, are available here.  I've published somewhat similar slides, relating to similar talks, in the past, but I am hopeful that this time around the slides provide a somewhat improved quick tour of the book's main content.

It was a good session, and I enjoyed seeing a number of old friends on the Duke and UNC law faculties.

Let a hundred schools of thought contend

Reuven Avi-Yonah has posted a very brief review of my international tax book in which he states his disagreement with it, and his continued adherence to views that I criticize in the book.  That's certainly fine - how boring it would be if everyone agreed, and I was no more surprised to learn that he still disagrees with me than he will be to learn that I still disagree with him.

To be very picky, I should note that I do in fact extensively discuss in the book the well-known international tax policy welfare norm of "national neutrality," which he appears to say that I don't discuss.  More importantly, I do not agree with his central argument, which is that, in opposing foreign tax creditability, I ostensibly ignore the fact that "no country is an island."  To the contrary, I'd say that it's largely because no country is an island that unreciprocated foreign tax creditability is an ill-conceived national policy.

NYU Tax Policy Colloquium, week 5: Chris Sanchirico's "As American as Apple, Inc."

Last week the colloquium didn't meet, as Tuesday was a "legislative Monday" at NYU Law School.  But yesterday we resumed with week 5, featuring Chris Sanchirico's paper, "As American as Apple Inc.: International Tax and Ownership Nationality."

The issue raised by the paper is as follows.  "Home equity bias" is a well-known phenomenon in the capital finance literature.  That is, despite the existence of global capital markets, it appears that investors around the world disproportionately own home-country equity, rather than globally diversified portfolios.  At least in the simple case where, say, the only way to invest in the U.S. is via a "U.S. company," this appears to fly in the face of basic principles of optimal diversification, causing home equity bias to be a "puzzle" badly in need of explanation, and possibly also a problem to be addressed.

The paper's focus diverges from that of typical entries in the home equity bias literature in two respects. First, in an empirical examination of what we know about U.S. home equity bias, it focuses on the question of who (as between Americans and foreigners) ultimately owns the stock of big U.S. multinationals in particular.  Second, the underlying reason for being interested does not pertain to explaining or trying to address the puzzle if any.  Rather, the paper notes that various arguments that commonly are made in U.S. international tax policy debate - in particular, as it happens, by people on the pro-multinationals side - take it as given that home equity bias is an important fact concerning the ownership of stock in U.S. multinationals.

Suppose, for example, that we are looking at General Electric versus Siemens.  These are in some ways similar companies, but GE is legally an American company under our place-of-incorporation rule, while Siemens is legally a German company under their headquarters rule.  Perception perfectly matches legal status, however.  Most people would say that GE is an "American company" whereas Siemens is a "German company."  But in the absence of home equity bias, U.S. individuals (and likewise German individuals) might hold roughly the same ownership percentage in GE as in Siemens.

Indeed, in this non-home equity bias scenario, U.S. individuals might even hold a lower percentage in GE than in Siemens, if holding the latter but not the former helped them to diversify against risks of the U.S. economy that they already bear by reason of working, living, consuming, etc. in the U.S.  But then again, since both companies are multinationals with investments around the world, we might well be pushed back, in the absence of home equity bias, towards expecting comparable ownership percentages for U.S. individuals.

It is widely assumed, however, that surely home equity bias does hold here, with the consequence that U.S. individuals are assumed to hold a MUCH higher percentage of GE than Siemens.  Just to capture what I am guessing might be the standard guess, perhaps the common view would hold that GE is, say 80% owned by American individuals, and Siemens, say, less than 5%.  But the paper says: "Not so fast - how confident should we actually be about this empirical claim?"

While the paper's main point concerns the lack of data that is actually reliable (despite multiple data sources), let's start by looking behind the data for a moment.  Suppose that, for all U.S. corporate equity, as defined by state incorporation statutes and including everything that is closely held, you could figure out the percentage that is owned by U.S. individuals.  Reflecting that some people who live in the U.S. incorporate in order to own and operate their own businesses, one would come up with evidence that appeared to show "home equity bias" but that actually conflated that phenomenon with the distinct one of what people do with their investment portfolios.  Now, just as a silly thought experiment, suppose we passed a law requiring all restaurants, fast food places, billiards parlors, and dry cleaning establishments to incorporate.  "Home equity bias" would seem to have increased, whereas in fact nothing of substance would actually have changed at the margin that interests us here.

It's one thing, already, to say that we're interested in publicly traded companies (which at least some of the data sources that the paper discusses generally don't break out as a separate category).  But the paper notes that multinational companies in particular are the poster child for those as to which you might expect LESS home equity bias, under most of the more credible explanations of the phenomenon in the literature.  So the paper argues, after going through the soft spots in one data source after another, that we really don't have any convincing evidence that stock in prominent U.S. multinationals is disproportionately owned by U.S. individuals.

A small additional word in furtherance of the paper's skeptical view of what we actually know about this: Suppose we actually knew who literally owns all the stock - including indirectly, by reason of looking through mutual funds and all such other intermediate entities to the ultimate individual level.  Even so, in a world full of derivative financial instruments (options, swap contracts, forward contracts, repo agreements, etc.), this might fall well short of telling us who really bears the economics associated with ownership of a particular company's stock.  For example, if you own the stock but we use a swap to transfer most of the economics of the share's performance to me, the data about legal ownership will be getting it wrong.  Derivatives, side bets, and all the rest make it even harder to figure out the underlying fundamentals than the paper's detailed and skeptical critique of the various leading data sources already suggests.

OK, why might all this matter?  The main reason I think  that it matters who "owns" (in the relevant economic sense) the stock of U.S. as compared to foreign multinationals, from the standpoint of U.S. international tax policy debate, is that (a) the entity-level corporate tax is a mechanism for indirectly imposing income taxation on the ultimate owners, and (b) we both do and should think very differently about taxing (whether directly or indirectly) resident individuals as opposed to foreign individuals.

For resident individuals, the main aim is to allocate tax burdens on the basis of some measure of some measure (e.g., income) that at least proxies for some underlying attribute such as ability or material wellbeing.  Hence, if we could, we would like to include, say, all of Bill Gates' income in the tax base, whether he earns it at home or abroad, and/or through a corporation or directly.

For foreign individuals, the idea is that it would be nice from, a domestic national welfare standpoint, to get $$ from them if we can.  So if we impose taxes on their activity in the US or through US corporations, and they bear this tax as a matter of economic incidence, then we are ahead of the game unless the associated cost to U.S. individuals (deadweight loss, decline in positive externalities from transactions with foreigners, etc.) is disproportionately high.  But this is a very different proposition from that for resident individuals, and in practice it may call for being resolved differently.  (For example, we probably don't want to tax the foreign individuals at all, in settings where we, not they, bear the economic incidence of the tax.)

Anyway, that's why I think the ownership data would be of interest, as one more potential input into evaluating all the issues in international tax policy.  (It's also of interest, of course, as a puzzle or non-puzzle in the capital finance literature.)  The main angle pursued in the Sanchirico paper, however, is somewhat different - not reflecting any particular disagreement, but merely because he is hunting different prey.

As the paper notes, pro-U.S. multinational proponents sometimes argue that the presumed predominantly American share ownership of U.S. multinationals provides support for (a) lessening the companies' U.S. tax burdens on competitiveness grounds and (b) viewing foreign dividend repatriation tax holidays as likely to increase U.S. investment.  The argument on (a) is that U.S. individuals are the shareholders who putatively are getting enriched.  The argument on (b) might go as follows: Suppose a foreign repatriation tax holiday is expressly permitted to fund domestic dividends and share repurchases.  Shareholders who were U.S. individuals ostensibly would be more likely to plow the money received back into the U.S. economy.

The paper says, in effect: Let's accept these contentions arguendo and ask if the underlying factual premise is true: Are the U.S. multinationals' shareholders disproportionately American.  We really don't know this, and people therefore shouldn't just assume it, thereby weakening the underlying arguments.

I myself, while recognizing that these arguments are being made in the U.S. international tax policy debate, don't regard them as strong ones - no matter how one comes out overall on the underlying issues.  Thus, I would be skeptical of their value and weight even if I were to accept (as I previously had been inclined to) the asserted fact of predominantly American share ownership of U.S. multinationals.

For example, I note that the "competitiveness" argument is not easily translated into a compelling claim that people who own U.S. multinationals' stock will earn extra-normal returns if, but only if, the U.S. doesn't tax the companies' foreign source income.  And I consider tax holidays a horrible idea because they give companies and investors the lesson that you should just wait for the next holiday.  Moreover, I would not expect the holidays to boost the U.S. economy unless we were to accept a not very compelling story in which liquidity constraints (at the shareholder level and/or the domestic firm level) are the big problem that is holding back national macroeconomic performance.

Overall, however, the paper offers a nice lesson in the merits of learning that perhaps you know less than you thought you knew.

Foreign travels

It looks like, over the rest of this year, I will be teaching or going to conferences or giving talks in Luxembourg, Italy, Brazil, Austria, and Canada.  Have United premier account, will travel.

Another winter storm

According to the online edition of today's New York Times, the West Side Highway "looks like rural Maine." Well, if that's true, I'm heading out there to pick blueberries.

NYU Tax Policy Colloquium, week 4: Thomas Brennan's Smooth Retirement Accounts

On Tuesday, Tom Brennan took the train down for Columbia (where he is visiting for the semester, from Northwestern), to present Smooth Retirement Accounts.

The paper discusses traditional and Roth IRAs from two perspectives: utility to the saver, and federal budgetary optics.  It then sketches out an alternative (the "smooth" retirement account) that would have Roth economics but different budgetary optics.

To explain: In a traditional IRA, your contribution is deductible, but your withdrawals are taxable (with tax-free inside build-up in between).  A Roth IRA contribution is not deductible, but the withdrawal is tax-free.

These two alternatives are economically equivalent if you simply earn the "normal" rate of return and if the tax rate is fixed.  E.g., say the tax rate is 50%, 1 year investment with a 10% return.  Under traditional, you might spend $200 out-of-pocket, which costs you $100 after-tax, and the account grows to $220, of which you retain $110 after-tax.  In the Roth, you simply deposit $100 of after-tax income and get $110, all of which you keep.

One key assumption that's needed for the two methods to be equivalent is that the investment be "arm's length" rather than, say, in your own business with labor income built in, so that you can only earn the normal rate of return.  E.g., if you can turn the first $100 you have into $100M because you're Zuckerberg and it's Facebook (but you can't keep going at that rate), then obviously you do better under Roth (at least, if you couldn't have parlayed $200 into $200M), reflecting that in effect labor income or rents or whatever you want to call it has been layered on top of the normal rate of return.

All this is familiar stuff in the biz.  Returning to the more particular analysis in the paper, a big difference in practice is that in Roth, the only tax rate that matters is the current one, so you're locked into it (assuming Congress doesn't renege down the line).  But in a traditional IRA, the future tax rate may differ from the current one, causing the investment to be tax-favored vs. Roth (or immediate consumption) if the rate declines, and taxed unfavorably if the rate goes up.  This could happen due either to changes in statutory tax rates or because of the progressive rate structure (e.g., you are in a lower rate bracket during your retirement years when you withdraw).

Brennan doesn't like this feature of traditional IRAs for two reasons.  It subjects the taxpayer to tax rate risk, and progressive rates can distort portfolio choices by reducing the relative payoff for investment with variability but high upsides relative to those that are relatively fixed.  So he prefers the Roth approach of avoiding downstream tax rate variability, though he wouldn't mind having the tax paid at the end (a la traditional IRAs) if it was locked in and equal to the deduction rate up front.

OK, the issue of progressive rates and portfolio choice is a broader one in the income tax (or in a progressive-rate consumption tax), though clearly he has a point.  Also a legitimate broader concern is the issue of tax rate variability distorting consumption choice between periods.  (A standard model consumption tax such as a VAT or retail sales tax creates this problem, of course, if there may be tax rate changes between years.  And suppose you are  faced, upon making your tax-free Roth withdrawals, with a newly enacted VAT.  Then you have indeed been "taxed twice," although it might not be viewed the same way as explicitly reneging on tax-free Roth withdrawal under the income tax.)

On the subject of tax rate risk, clearly it would increase people's utility if, in response to future tax rate risk, they could purchase, for a suitable price, private insurance locking in the current rate for them.  Under such a hypothetical insurance system, I'd pay, say, 35% no matter what, and the government would collect based on the actual future rate no matter what, but the insurance company would pay the extra on my behalf if the rate went up, and take the difference out of my hide if the rate went down.  This of course is just a thought experiment, not real life or a practical proposal.  Presumably one reason such insurance doesn't exist is that the insurer would have difficulty reinsuring or spreading the risk.  And there would also be moral hazard issues if the payments depended in part on how much income I actually had in the later period.  But I mention it just to make the point that, while such insurance presumably would be a good thing for consumers if feasible, that doesn't mean that it's optimal for the government to allow people to lock in their future tax rate.  That leaves other taxpayers as the "counterparty" without any insurance premium.

Example 1, you lock in the current rate in June 1941, then on December 7 it turns out that taxes will have to go way up to pay for a million-soldier, two-front world war.  Taxpayers who locked in the earlier rate have concentrated the revenue risk on everyone else.  Case 2, President Romney imposes low rates, then the following year President de Blasio enacts high rates.  So it's a change in political preferences, not "objective" needs, but here it's at a minimum unclear whether or not we should view allowing an earlier-year opt-out as socially beneficial.

Anyway.  As Brennan agrees, it's a complicated question to what extent we should want tax rates to be locked in, despite the clear benefits at one particular margin to enabling this.  The point, of course, is that these are complex and interesting issues, not that the paper is "wrong" to use correct analysis of one of the relevant margins to show an advantage to locking in the rate.

Issue 2 is budgetary accounting.  With a short-term budget window, traditional IRAs look costlier than they actually are, since the deductions are counted but the later year inclusions are outside the budget window.  Roths look cheaper than they actually are, since Congress is only giving away the out-year revenue (plus the tax on inside build-up within the budget window, but that may be just a small part of the whole).  Worse still, as Congress showed through budgetary shenanigans in 2010, you can lose long-term revenue by "bribing" people to switch from traditional to Roth IRAs, yet score it as a revenue gain within the budgetary window that you use to pay for other tax cuts.  In that scenario (which, again, actually happened), tax cuts (from the bribe that is offered to prompt Roth conversions) are used to "pay" for other tax cuts.

Brennan has an intricate plan in mind that could work as follows.  You use a traditional IRA, in the sense that there is an up-front deduction.  But as in a Roth IRA, there is no tax rate risk, because you are guaranteed that the withdrawal will be taxed at the same rate that applied to the deposit.  But to improve the budgetary accounting, each year a suitable fraction of the accruing future tax liability would be counted as current revenue gain for budgetary accounting purposes.  The deemed tax revenues for budgetary accounting purposes are the source of the adjective "smooth," but, as this is already a long blog entry, I will refer you to the paper itself (see the link above) for the precise mechanics.

The budgetary optics problem has a straightforward solution, which is simply to do infinite horizon budgetary accounting rather than artificially truncating the out years that are deemed to be within the budgetary window.  Obviously, this raises issues of its own that a large literature has examined.  Next best might be coming up with ad hoc budgetary rules that replace pure cash accounting, for both Roth and traditional IRAs, with something that is the same for both of them and also closer to economic accrual than the cash flow treatment of either way.  The paper offers one way of moving in that direction.  But once you are not going all the way to accrual, by eliminating the budget window, it comes down to a choice between imperfect alternatives.  Brennan, who at all times is extremely and indeed completely fair-minded, agrees with this analysis.

Column in local paper

One of the nice features of my neighborhood in the West Village is a local paper that comes out every month, called Westview, which covers local issues, such as the loss of St. Vincent's Hospital (leaving much of lower Manhattan without a nearby hospital or emergency room), along with cultural news and the like from our area.

I write occasional short pieces for Westview, which also was nice enough, a few years ago, to run a feature relating to my novel, Getting It.

Anyway, in this month's issue, I wrote a short op-ed called "Mayor De Blasio's Plan To Increase Taxes on High-Earners."

I encourage those who are interested to click on the link and also to look at other features in Westview.  However, here are some highlights from my piece (which overall is only about 500 words):

In the recent mayoral campaign, then-candidate Bill de Blasio’s signature proposal was to address New York’s “tale of two cities” – the extremely rich versus everyone else – by increasing the City’s income tax rate for people with incomes over $500,000, from 3.9 to 4.4%. ... [D]oes the tax policy literature (in which I write professionally) support viewing the proposed tax increase as a good idea? I believe that it does ...

The literature on state and local taxes strongly suggests that, as a general rule, it’s wise to leave progressive taxes to the national level, rather than imposing them sub-nationally (such as in a given city or state). The reason is potential exit from the taxing jurisdiction by high-earners. For example, if one town raised taxes on high-earners while all of its identical neighbors did not, it’s a fair bet that many of the intended targets of the tax would simply leave. Exiting the entire country, if federal income taxes go up for the wealthy, is a lot costlier for taxpayers to execute, and thus is not as much of a problem (Facebook’s Eduardo Saverin notwithstanding).

However, New York is not just one in a sea of identical towns. It has genuine market power these days, as a global destination city like London and very few others.... Clearly, high-earners are willing – at least, up to a point – to pay a premium to live here.

Thus, even if you don’t share Mayor de Blasio’s (and many voters’) discomfort with rising high-end inequality, it would be foolish for New York City not to take advantage of its privileged, albeit not quite impregnable, position. So long as we can secure significantly more tax revenues, with only relatively modest behavioral responses (such as exit by high-earners), it would be like leaving money on the table for the City not to try to extract a bit more.

Obviously, this argument – like that for increasing the minimum wage – can only be pushed so far. Overdo it, and you shoot yourself in the foot. The more the tax on high-earners goes up, the more tax base is likely to be lost per dollar of revenue raised. At some point, one would even run into the Laffer Curve, where raising the tax rate actually loses revenue. In my view, however, we are still well short of that point.

Suppose the de Blasio plan is enacted, and it proves a success. How much will it do to address our “tale of two cities?”  ... [T]he answer is: Not all that much. New York City is a cork bobbing on the waves of the global economy. Overall global trends pertaining to high-end inequality will accentuate – or else not – depending on factors that the City cannot control or even much influence. Yet so long as those trends do continue, and so long as we continue to be a favored global destination city – an asset that we must assiduously preserve – taking modest advantage is not wild-eyed radicalism, but simply sober common sense.

UPDATE: A comment that I received offline from a correspondent has persuaded me that I should not be so certain of the accuracy of my assumption in the above piece that NYC is below the peak of the Laffer Curve for the super-rich.  For example, if the City raises their income tax rates, they don't have to sell their pied a terres but can be more careful to beat the NYC residency rule.  Meanwhile, if they are in town less for this reason, it's conceivable that NYC-area consumption will fall, leading to adverse multiplier effects on NYC even if not national tax revenue.  I would certainly welcome any studies or good empirical assessments of this issue that anyone may have available.

New short article published

Last summer, the Hebrew University in Jerusalem conducted a book symposium on my (as of now) recently published book, Fixing U.S. International Taxation.  The people commenting on the book were Stephen Shay of Harvard Law School, Yariv Brauner of the University of Florida Law School, and Fadi Shaheen of Rutgers-Newark Law School.  I offered a brief response to their comments, and their papers plus my response have now appeared on-line courtesy of the Jerusalem Review of Legal Studies, which is publishing them in its first 2014 issue.

My response is available on-line here.  At least, I think it's available. Readers may find (and if so, can let me know) that they need an Oxford / JRLS subscription to open the link.

I would be happy also to offer links to the three comments, but here I'm pretty sure that a subscription is indeed needed to read them.  The page that one would go to, in order to access them, is here.

Signs of age

This Sunday will be the second time in my life that there has been a well-publicized fiftieth anniversary of a public event that I am old enough to remember.  This time, of course, it concerns the Beatles' appearance on the Ed Sullivan Show on February 9, 1964.

The first famous event that I can remember from fifty years later was the assassination of President Kennedy.  I recall my first grade teacher being called out of the room to hear something on the radio.  This seemed very odd, and had certainly never happened before.  Then she came back in and told us the news.  I found it surreal (not that I knew the word), not just because I was so young, but also because those were such innocent times for people growing up in the U.S.  In retrospect, so far as dark events are concerned, there had already been the Cuban missile crisis, not to mention that crazy things had been happening in Vietnam, such as monks burning themselves and the Diem assassination.  Go back less than twenty years, and one had the Holocaust.  But I am pretty sure that I knew little or even nothing about all that.  I was living, so far as I could tell, in more of a Disney-style universe.

Then, over the weekend, Ruby shockingly shot Oswald.  I recall our discussing it in class, presumably on Monday. By now the whole run of events felt truly unfathomable and incomprehensible.  I remember making a comment in class about how all these shootings were like cowboys and Indians.  But even as I said it, I felt that it was inadequate and had failed to convey what I meant (which I evidently couldn't put into words, but had more to do with perplexity than grief).

Anyway, next came the Beatles.  I was too young to comprehend the weeks of national gloom that their arrival evidently broke.  Nor did I know anything at the time about the famous airport press conference, the girls staking out the hotel, Murray the K playing them around the clock, and so forth.  But I did know that my older brother had successfully petitioned my parents to watch the Ed Sullivan Show at 8 o'clock.  My regular bedtime was 7:30.  Whatever this "beetles" or "Beatles" thing was, I didn't want to miss out just because I was younger.  At the same time, however, I had no clue about who or what they were.  I was unaware, not just of the "a" in Beatles, but even of their being a musical group.  I believe I was envisioning some sort of exciting mechanical, metallic buzzing "beetles" that would be fun to watch on our black-and-white TV.

My parents allowed me to stay up for the Sullivan show, so long as I was ready to go to bed immediately afterwards.  But the moment I heard them, I said "I'm going to bed now."  At that point, growing up in my household, I am fairly certain that I had never heard rock music before.  (If my brother had gotten to hear them on the radio, I hadn't noticed.)

That's it for my contemporaneous memory of the Beatles' first appearance in America.

"Awww..." photo of the day

Little Gary, shown here courageously entwined with a cloth crocodile, has enjoyed a 700 percent weight increase since we first adopted him, at the age of about six weeks, in September 2012.  He is now just over 9 pounds.

NYU Tax Policy Colloquium, week 3: Victor Fleischer & Nancy Staudt's "The Supercharged IPO"

Today in the Tax Policy Colloquium, we discussed the above paper, available here, albeit with technical limitations on the session.

Of the two authors, only Nancy Staudt was able to attend.  By the way, she was our second-ever colloquium guest, back in January 1996, when she presented her paper, Taxing Housework.  (Our first guest ever was Louis Kaplow discussing state and local taxes; in week 3 we had Bill Andrews discussing corporate taxation and the new view.  My co-convenor at the time was David Bradford.)

Anyway, Nancy, unfortunately but understandably, had to leave early.  She barely got in yesterday from Los Angeles, switching to a flight that wasn't canceled by yesterday's East Coast storm, and I gather managed to escape this evening just ahead of tonight's East Coast storm.  But this required her leaving our session early.  I could certainly understand the problem; twice in the last few years I've been trapped in Los Angeles (mid-semester) for 48 extra hours due to an East Coast storm.

To fill the gap, Victor Fleischer participated (from San Diego) by Skype.  I really don't like doing this because the technology still isn't so great, unless you have a higher capital investment site than NYU can offer.  Vic apparently heard less than half of what was being said on our end, and inevitably we had lag, Internet freezes, etcetera.  But it was good to have him participate even virtually, and this enabled us keep the session going under some simulacrum of quasi-normality for the full time.

Anyway, the topic of the paper is a type of deal that has gotten some attention in the tax press, known as a "supercharged IPO."  As discussed in the paper, these deals have two main attributes, and the relationship between the two was a main topic of interest.  The first attribute is that, in certain initial public offerings (IPOs) in which a given start-up company is taken public, the parties deliberately arrange a taxable, rather than a tax-free transaction.  The second attribute is that, in a very few deals but these being the ones that were studied in the paper, the parties agree to a "tax receivables agreement" (TRA).  Under a TRA, the buyer agrees to make certain payments to the seller, in effect as deferred installment sale payments, the amount of which depends on the tax savings realized by the buyer, post- transaction, from tax attributes acquired in the course of the deal (and enhanced by the fact that the deal was deliberately made taxable).

OK, let's give an example, before turning to the fact, which came out during the session, that this was not generally the universal or even typical pattern in a "supercharged IPO."  Suppose the following.  A highly successful start-up business, conducted as a partnership, has assets with a value of $1 billion and a tax basis of zero.  Suppose that all of the assets would yield capital gain, taxable (during the pre-2013 years covered by the paper's data analysis) at a 15 percent rate.  In other words, no depreciation recapture or "hot assets" (to use the operative tax lingo) that would be taxed at the ordinary income rate.  Suppose, moreover, that if the assets were newly acquired, they would get 10-year straight line depreciation.  Thus, if acquired for $1 billion, they would yield depreciation and amortization deductions of $100 million per year for 10 years.  The tax savings would be $35 million per year for 10 years at the 35 corporate tax rate, assuming that the taxpayer always has enough taxable income for the year to claim all of the available deductions at that rate.

OK, suppose the taxpayers could sell the asset to themselves for $1 billion, for tax purposes.  They'd pay $150 million of tax on the $1 billion capital gain.  Saving $35 million per year from the cost recovery would yield them the equivalent of a 10-year annuity (again, assuming certainty of realizing the full value).  These tax savings would have a present value of $270 million if one uses a 5% discount rate.

Therefore, the self-sale, if permissible would save $120 million of tax in present value.  While you can't do that, using an IPO to do it arguably applies the following.  In a competitive market, buyers who would have paid $1 billion just for the assets should also pay $270 million for the annuity, so the total sales price, in a taxable deal, should be $1.27 billion rather than just $1 billion.  (To keep the arithmetic simple, I am ignoring the fact that this changes all the relevant dollar amounts, and thus the true amount might settle a bit further north.)

OK, so if this is the right scenario to be thinking about - and knowledgeable practitioners in the room suggested that perhaps it actually is not - then Conclusion 1 is that, obviously, the parties should do a taxable rather than a tax-free deal.  No need for a fight between sellers who'd want to avoid tax and buyers who'd want to maximize their deductions, since the right way to approach the problem is as one of collective tax minimization.  Once you've made the "pie" as large as possible, at the expense of the fisc, there's plenty of time to divide the loot between the two of you so that you're both better off.  E.g., at a $1.27 billion price, the buyers get fair value while the sellers are compensated for their $150M tax liability by a $270M increase in their sale price.  (Yes, I realize still that I am not fixing the numbers to include the capital gain on the extra sale price, etc.)

Let's call this the underlying "tax arbitrage" here (offsetting 15% & 35% rates create a net tax saving despite the adverse timing of having income before deductions).  But that just concerns doing a taxable rather than a tax-free deal.  (Practitioners suggested, however, that more realistic scenarios include (a) sellers are going to realize gain anyway, by selling the stock they acquire within a few months even if it's a tax-free deal, so why not get the basis step-up, and (b) a separate set of considerations that guide purely corporate transactions.)  Even if we accept the scenario, however, what we haven't explained is why the parties, at least in a small set of cases, might include a TRA.

A typical TRA might provide the following.  For each of the next 10 years, Buyer shall make a payment to Seller that equals 85% of the tax savings enjoyed by reason of the tax benefits.  So under my facts, each year 85% of the $35 million tax benefit from the cost recovery deductions (i.e., $29.75 million) would be paid to the Seller.

OK, again for arithmetical simplicity, let's make it a 100% TRA, so the annual payments are $35 million.  (This is frowned upon in practice, of course, because it would wholly eliminate the Buyer's incentive to actually use the tax benefits.)  With a 100% TRA, the mechanism for paying $1.27B to the Seller might be $1B up front, plus $35M per year for 10 years.  The question is, why do this?  $1.27B in present value can be paid whether you use the TRA or not.  And even if you want some deferred payment, why should it depend on the tax benefits.  Use or non-use of the TRA should be a matter of complete indifference to the parties - indeed, whether or not they have done a taxable deal, unless there is more to the story.

Here are the 6 theories we discussed that might explain the use of TRAs in practice:

(1) Buyer myopia - Just about everyone who actually knows about these deals insist that the form reflects buyers' failing to value the tax benefits appropriately - and at the limit, valuing them at zero.  "That's what the bankers tell everyone," the tax lawyers in the deals will explain to you if you ask.  This seems decidedly odd as it implies a market failure that seemingly could be exploited by savvy arbitrageurs (or simply higher bidders) who understand the value of the tax benefits.  But if we assumed it were true, it would make use of the TRA an efficient mechanism between the parties.  You assign a given asset to the party that actually places a higher valuation on it.  As we will see, while this theory may remain hard to accept, arguably all the other theories fare even worse.

(2) Careless buyer doesn't read the fine print - To put this in the strongest possible form, although in practice it may overlap with Theory 1, suppose the Buyers are willing to pay $1.27 billion as that is the value of the business assets plus the tax assets, it fails to read the fine print at page 496 of the transaction documents.  Hence, they fail to realize that they are paying twice for the same tax assets: once up front and a second time through the TRA.  This is an even harder theory to credit - TRAs are apparently highlighted not smuggled in - but it starts to look more like Theory 1 if we posit that the Buyers don't so much overlook the TRA as value it at zero (in the extreme case) due to their mysterious myopia about the value of tax assets.  And in the intermediate case it's just the way they prefer to pay the overall sale price, since they have a lower estimate of the tax assets (even if not zero) than the Seller.

(3) TRA spares the parties the trouble of having to value the tax assets - Rather than fight about how much they're worth, why not just assign them to the Seller through the TRA.  But the question here is, why are they harder to value than everything else?  You have to figure out how much the company is worth, and once you're projecting annual pre-tax and after-tax earnings you're pretty much there so far as valuing the tax assets is concerned.  So this theory is less than wholly persuasive.

(4) Buyers don't like the risk associated with the tax assets - Will the IRS allow them all?  Will there be sufficient taxable income to use them in full right away?  But if we view this purely as a matter of risk aversion, it seems peculiar in this context.  Typically what's happening in an IPO is that the entrepeneurs who bear a concentrated business risk are selling it into the general marketplace in order to diversify.  The buyers already were diversified and remain so (indeed, they may become a hair more diversified by reason of doing this).  So why would the buyers be more averse to the tax risk here than the Seller?

(5) Lemons problem from asymmetric information - OK, now it might seem that we are finally getting somewhere.  This was my favorite theory going in.  Suppose the Seller knows more than the buyers about the true value of the tax assets.  Is it overstated?  Are they subject to successful IRS challenge?  With asymmetric information, they have the used car problem.  Even if the tax assets truly are worth what they seem, how can they prove this to the buyers?  The very fact that they are selling creates a bit of natural suspicion that this is what motivates them.   Now, the lemons problem clearly can be a big problem in selling stock to less-informed third parties.  But why is it distinctively associated with the tax assets?  E.g., asset basis is negotiated in the deal and may be hard for the IRS to challenge.  Future profits that would permit the tax benefits to be used in full is already an issue on asymmetric information grounds.  How much worse do the tax assets make it?  Plus, apparently in the typical TRA the buyers' payment to the Seller is based on the tax benefits claimed, and no refund is subsequently due from the Seller if the IRS disallows tax benefits on audit.  In sum, therefore, it is hard to really get this theory off the ground.

(6) Upselling by the lawyers - They want to be able to charge for arranging a TRA, so they tell the parties what a great idea it is.  Only, it's apparently the bankers who push for these things, and they aren't increasing their own compensation by doing this unless this makes the deals higher-priced overall or easier to close. 

So even though I don't like Theory 1, I am pushed back towards accepting it by the universal testimony of the players plus the weakness of the alternative theories.

If one accepts all this, what should one think of TRAs?  They look pretty innocuous, serving merely as devices for permitting efficient pricing and costing the IRS zero on any deal that would have been made with the same overall price terms in any event.  (Tax attributes aren't traded from lower-valuing to higher-valuing parties - it's just the after-tax benefit that they shift around.)  There would be an SEC / capital markets / consumer protection for banning them if we believed, as under Theory 2, that they are a device for duping investors into overpaying.  But that is hard to credit given how prominently they're disclosed.

So about the best one can do, if one wants to argue against them, is to claim that they are associated with the ability to execute tax arbitrage deals (like my $1B / $270M example above) that otherwise would founder due to differential valuations by the parties of the tax benefits.  In other words, in this scenario one would ban TRAs in order to discourage tax arbitrage deals by impeding efficient pricing of the deals.  (Note, however, that you can also potentially use a TRA in a tax-free deal.)  But this one as well is pretty hard to credit.  To what extent do we believe that impeding efficient pricing would actually impede "bad" deals while leaving "good" ones (e.g., those where people just want to diversify) unharmed?

I conclude both that there is no particular reason to go after TRAs - instead, address the tax arbitrage directly if one is concerned about it - and that they are simply aren't that big a deal from the policymakers' standpoint.  But still interesting to discuss at the session.

Front row seat

Sometimes Gary watches the ball (since it's small and moving), other times the players running up and down the court.

AEI session on corporate tax reform

It's been a tiring, or should I say taxing, 24 hours.  Last night at about this time (just after 6 pm as I type these words) a small group of us was heading to a really good local restaurant, Po on Cornelia Street in Greenwich Village, for our customary post-colloquium small group dinner.  By 8:15 I was cabbing to Penn Station, in order to take the 9:05 pm Acela to Washington, DC, so that I'd be there for the American Enterprise Institute session on corporate tax reform that will soon become the topic of this post.

Bad evening on Amtrak, however.  A two-hour train delay, poorly explained as it was ongoing, meant that I didn't get to my hotel room in DC until 2 in the morning.  Then my train home today was cancelled, though I was able to scramble and get back in a timely fashion anyway.

But anyway, about the session.  Entitleed "Corporate Tax Reform: Where to From Here?," it provided a platform for Laura D'Andrea Tyson, Martin Sullivan, and me to say where (if anywhere) we think things might be headed on this front, and why.

You can see the entire video of the event here.  I believe it was reasonably lively.  In addition, you can see the Power Point slides for my talk here.

Sullivan and I were comparably pessimistic, not just about the politics, but also about the overall merits of the types of corporate tax reform plans that are being floated today.  Bad though the current system may be (and indeed is), it's such a tangled kind of a mess that efforts to take a couple of steps in one direction or another tend to have really serious drawbacks.  It's a bit like Pin the Tail on the Donkey, when you've been spun around so many times that all you can do is stagger blindly in a circle, except that, in that game, there actually is a clear right direction, if only the dizzy and blindfolded participant could find it.

While we mainly discussed domestic corporate tax reform issues, we also spent some time on the international aspect, given how closely entangled those two strands are these days.  Sullivan was kind enough to bring my international tax book to the session, and to several times hold it up and recommend it, with very kind accompanying remarks that I would certainly not, for my part, be inclined to quarrel with.

Shaheen's colloquium paper on the repatriation tax and lockout, part 2

OK, at the end of my last post I had laid out the new view and noted Shaheen's reliance instead on managerial accounting incentives to explain lockout in the international realm.  Managers of publicly traded companies love to have high financial accounting income, even at the expense of favorable economics, so I suppose they do all they can (bake cookies, issue firing threats) to persuade their accountants that particular foreign source income of their overseas subsidiaries has been permanently reinvested abroad.  This causes the deduction from financial accounting income for the deferred U.S. repatriation tax to flip on a dime to 100% of what it would be if incurred today, to zero.  Sounds really stupid as a matter of rule design, but I am not an accountant.

Anyway, once they declare PRE (permanently reinvested earnings) they can't bring it home without both (a) taking an earnings hit from the repatriation tax, if any, and (b) making the accountants feel disrespected and hence more skeptical about other PRE claims.  So Shaheen posits that it's fruitful to think of the PRE as if it simply cannot come home.

Note, by the way, how bad for the shareholders this is.  The PRE designation doesn't make actual taxes lower - it just causes the possible future repatriation tax, if any, to be reported differently.  But once we build in a constraint on managerial behavior to the effect that the funds now can't come home, we are in the scenario where the company may keep funds abroad even if (a) the new view holds sufficiently that they in fact can't reduce the expected repatriation tax via optionality by deferring it, and also (b) they are earning less by reason of keeping the funds in broad.  In short, the value of optionality aside, the PRE designation may induce managers to make shareholders worse-off - from the company's being genuinely less profitable after-tax over the long haul - simply due to their mania for high reported earnings and/or their being subject to a binding PRE constraint once they have voluntarily subjected themselves to it.

The paper explores the possibility that the firm would benefit from investing locked-out earnings in passive assets, even if they earn a lower after-tax rate of return than available active-business investment opportunities that are available to the form.  The idea is that, because the passive income is taxed currently and thus can't become PRE (there are no deferred taxes to claim you will be permanently avoiding), the firm is now free to invest properly from the shareholders' standpoint, including by bringing the money home if the best opportunities are here.  At the same time, the paper concedes that managers may not feel inclined to do this, given that they like to defer the current repatriation tax (even if they are not reducing its expected value) so that reported earnings can be boosted via the PRE route.

Same point holds for active income earned abroad that the managers are able to resist giving PRE status.  A key broader conclusion from the paper is that it highlights some of the costs of the deferral regime once the new view either doesn't hold or is being ignored for accounting reasons.  Hence my view, discussed at some length in my book, that it is important to try to delink intellectually the questions (a) what should be the domestic tax burden on foreign source income from (b) what do we think of deferral and the foreign tax credit, which are two singularly awful ways of lowering that tax burden other than by expressly applying a lower statutory rate to it.

NYU Tax Policy Colloquium, week 2: Fadi Shaheen's "The GAAP Lock-Out Effect and the Investment Behavior of Multinational Firms"

Yesterday at the colloquium, we discussed Fadi Shaheen's above-titled paper, which is available here.

As background to the paper, the "new view" of dividend repatriations demonstrates that, if the U.S. repatriation tax for multinationals' earnings through foreign subsidiaries remains in place indefinitely at a fixed rate, and if repatriation at some point, at this fixed rate, is inevitable, then there is no lockout so far as shareholder-level economic incentives are concerned.

Thus, suppose for simplicity that there is only a U.S. tax, with no source-based foreign tax.  Let's call the U.S. repatriation tax rate t, the per-period after-tax rate of return r (let's also make things simpler by assuming that you get the same after-source-tax return everywhere), and the amount of foreign source income that is at issue X.  If the U.S. parent repatriates X immediately, it ends up with X(1 - t), and then at the end of the period it has X(1 - t)(1 + r).  By contrast, if it repatriates at the end of the period, it has X(1 + r) to repatriate, and doing so leaves it with X(1 + r)(1 - t).  Obviously (and it's a good thing too), we don't need advanced math skills to conclude that X(1 - t)(1 + r) = X(1 + r)(1 - t).

While you can kill the strict equivalence with different after-source tax rates of return as between home and abroad, all that shows is that it's desirable to keep X where it earns more, rather than less - not that the repatriation tax is discouraging repatriation.  What makes the equivalence work is the fact that deferring the repatriation tax takes today's prospective liability and both discounts it at r (since it's better to pay a fixed sum later rather than now) and causes it to grow at r (since the amount to be repatriated keeps growing).

While this is an important conceptual marker that improves one understanding of the relevant incentives, the bottom-line conclusion - no lockout - is not true, because the underlying assumptions are not true.  In particular, keeping they money abroad has option value, since you can simply wait for the repatriation tax rate to drop.  This is especially significant when we don't just have an expectation of random walk changes in the future history of repatriation tax rates, but rather there is a very real chance that it will go down by reason of a tax holiday, corporate tax rate cut, or the enactment of another tax holiday like that in 2004.

Hence there's significant lock-out, contrary to the new view model, because only the fools among corporate CEOs and CFO's would believe that the repatriation tax rate is fixed.  And whether or not these individuals are as brilliant as their paychecks are fat, they are certainly smart enough to realize that.  (Further point: It's not clear that a taxable repatriation is inevitable even if we are comfortable with viewing all wealth as ultimately consumed.  If capital markets work well enough, the FSI could effectively be repatriated, put in shareholders' pockets, and consumed by them without there every being a taxable repatriation.)

In the paper, howevcr, Shaheen explores the possibility of lockout if the new view is actually correct, rather than merely being an important explanatory tool.  (But just one last comment on the new view - saying it's "false" in practice is no more a criticism than saying the Coase Theorem doesn't hold because there are transaction costs.  That's actually, at least arguably, the point - to show us where the relevant bodies are buried.)

The paper discusses an alternative, and indeed complementary rather than contradictory explanation for lockout, which is that publicly traded firms tend to have corporate governance problems, which cause the managers to care about current or near-term financial accounting income, at the expense of actually maximizing present value.  Accordingly, they seek the accounting status of "permanently reinvested earnings" (PRE) which they have persuaded their accountants will never come home.  Once PRE status is attained, the deferred repatriation tax, rather than being charged against earnings as a current expense (without regard to the fact that it hasn't been paid yet), is completely ignored - valued at zero, since supposedly it is irrelevant once the managers swear on a tall enough stack of bibles that they will never repatriate particular funds.

This entry is already rather long, so I will post it now and resume in a follow-up.

Maybe this time it will work

Since last spring, I've been interested in writing about behavioral economics and retirement policy.  In particular, I've had in mind the "nudge" literature - for example, Raj Chetty's important study along with a number of others that reach similar findings, Richard Thaler's and Cass Sunstein's book on nudges, and their related article on libertarian paternalism.  These seemed to me to offer fertile and timely ground if interacted (so to speak) with both my older and my more recent work on Social Security.

But as you can perhaps see already from the way I have stated the underlying motivation, this project has been far more a bunch of thoughts and ideas in search of an overall framework, than a crisply structured project.  So I was having a lot of trouble with this article idea last summer, although I did reach 30 pages or so in a fourth try that I then had to shelve for 5 months due to a host of other commitments.

By the time I had gotten my nose close enough to the water's surface to think about how I should proceed upon resuming the project, it had become clear to me that the current structure (such as it was, and if one even call call it that) was unsound.  My next idea was to break it into two pieces, one about savings "incentives" (from an income tax perspective) vs. default rules vs. expanding Social Security benefits, and the other about libertarian paternalism.  But this pair of projects didn't quite feel right either.

Today I am hoping - although still far from 100 percent certain - that I have finally gotten my hands around the project in a constructive way.  The current plan has the tentative title "Multiple Myopias, Multiple Selves, and the Under-Saving Problem."  If it does work out - which I won't really know until I've invested more hours in it - and if my schedule over the next few months proves kind to me, then perhaps I might even have it done by May.

If the current plan does indeed work out, it will have illustrated once again how much better people (I don't think I'm unusual in this regard) sometimes are at working "off-line."  That is, when you're vexed by a problem, sometimes the best thing to do is get good and frustrated, then spend a couple of days not thinking about it.  Always a great feeling if / when the off-line mental functions, operating beyond or beneath one's consciousness, turn out to have been studiously beavering away, such that when your conscious mind re-engages you soon find out that you have a solution.

Of course, I hope I'm not jinxing the process by implying prematurely that I have indeed found the path at last this time around.

When is a class not a class?

Depending on how you define your terms, yesterday either did or didn't witness the semester's first PM meeting of the NYU Tax Policy Colloquium, in its nineteenth year of operations.

The introductory AM class, which is private (i.e., just for the enrolled students) went off fine despite the approach of threatening weather.  But the public PM session, scheduled to meet at 4 pm, ran into a bit of a hitch when it was decided, at about 3 pm, to cancel all NYU Law School classes for the day that were scheduled to begin at 4 pm or later.

This was an entirely reasonable, and indeed probably necessary, decision given the steadily falling snow, severe temperatures, and threat of travel disruptions for people not living in the immediate area.  But when you have your speaker at hand from out-of-town, have prepared extensively for the discussion, and have separately met earlier in the day both with the students and with the author to lay the groundwork for a good session, it's less than entirely welcome.  We ended up holding a voluntary session (i.e., not an official class at which student attendance was expected) and had a good discussion notwithstanding.

Yesterday's author was Saul Levmore, discussing two short papers (available here and here) concerning internalities and regulation.  Consider mandated saving (such as under Social Security) or cigarette taxes and smoking bans.  The papers contrast the "old view," in which the underlying regulatory aims sound in externalities or paternalism, with a "new view" in which they instead aim to address people's self-control problems.

At the risk of headlining mere semantics, I don't view these alternatives as "old view" versus "new view."  Usually, when we contrast such things, the two views actually contradict each other.  The "old view" of corporate dividends holds that the shareholder-level tax discourages paying them.  The "new view" shows that there is no such discouragement under specified circumstances.  The "old view" of transition relief holds that, when there is a legal change (such as repealing the income tax exemption for municipal bonds) relief such as grandfathering should be granted, in order to protect reliance interests.  The "new view" instead emphasizes incentive effects from anticipation, and thus in many circumstances favors not granting transition relief.

But in the internalities / regulatory setting we instead get related and somewhat overlapping rationales for approximately the same policies.  For example, one can favor forced saving via Social Security both so the elderly won't need public support by reason of indigence and to help them optimize, if we fear they might otherwise save too little from the standpoint of their own long-term self-interest, although it is true that the two alternative rationales may have different implications for program design.  (E.g., the fiscal externality would suggest requiring just enough saving to avoid public support, and indeed would suggest nothing if public support were repealed.)

I also would quibble with the papers' definition of an internality, which they extended to cover collective action problems in which each individual is acting rationally and time-consistently.  An example that the papers discuss is helmet regulation.  In many places that don't require motorcycle helmets, nobody wears them.  Arguably, the riders have some desire to wear the helmets for safety but don't want to out themselves as nerds by doing so.  But once a helmet is legally mandated, you can get the safety without causing people to view you as a nerd.

This example (probably in truth, but certainly under the stipulated facts) is a benign example of regulation working well, but I wouldn't say that it addresses an internality problem.  After all, it's entirely rational not to want look like a nerd.  (As Hume famously said, reason is merely the slave of the passions, and most of us have "passions" that extend to caring about how people perceive us.)  There is no time-inconsistency or self-control failure in this story.  Rather, it's an externality issue - if I don't wear a helmet, I affect the social meaning when someone else does - that may be difficult to solve privately due to collective action problems.

More generally, I don't have the sense that internalities transform the regulatory analysis as much as the papers suggest.  Within neoclassical economics, allowing for internalities is a radical step because it challenges the basic rationality assumption, as well as greatly muddying the effort to discern preferences and utility from behavior.  But once you allow yourself to take this step, the analysis goes forward in largely familiar ways.  (Not entirely so, because the potentially missing "transaction" is between present and future selves, rather than different people.)  The papers have some interesting things to say about how interest group politics and information problems in discerning the proper policy can be big issues in a regulatory setting where internalities are important.  But this is also the case if one just has externalities to deal with.

Although I don't here comment on the sessions themselves, in order to preserve their being off-the-record, I will note that Levmore is always good value as a speaker and guest, which is one reason we scheduled him for Week 1, and also helps to explain why I did not want to lose the session.

Ads I'd like to see (or perhaps not really)

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New article posted on SSRN

I have just posted on SSRN a new article, entitled "The Economics of Tax Law."  Despite the scope implied by the title, it's just 30 pages / 9500 words.

The abstract is as follows: "This working paper is a forthcoming chapter in the Oxford Handbook of Law and Economics, edited by Francesco Parisi.  It provides a brief overview of economic issues in tax law, including distribution and efficiency in general, the role of administrative and political economy concerns in an income tax, the choice between income and consumption taxation, the significance of entity-level taxation of corporations, and the issues raised by base-broadening tax reform."

I am considering adding a short section addressing the basics of tax incidence, an issue which at present I only mention a few times in passing.  The problem is that I am only 500 words shy of my overall word limit.

The article is available for download here.

I am hoping that it has some potential to serve as a useful overview/intro paper, such as for law students in tax and tax policy classes.

D.C. corporate tax event

On Wednesday, January 29, from 9 to 10:30 am, the American Enterprise Institute will be hosting an event called "Corporate Tax Reform: Where to From Here?"  Alan Viard will be the moderator, and I am one of the three speakers, along with Marty Sullivan and Laura D'Andrea Tyson.

The event description reads as follows: "Economists often condemn the inefficiency and complexity of the US corporate income tax, and politicians on both sides of the aisle advocate reform. Yet the US corporate tax code has remained largely unchanged for decades. Has the time come for reform? What would an ideal corporate income tax look like?"

This is meant to be open-ended, however, and I will talk more about the muddle of the existing system and the dilemmas that it confronts us with.  I've prepared PowerPoint slides, entitled "Stand-Alone Corporate Tax Reform?," that I plan to post after the event.

Profiles in courage

Sylvester defends the home front against an invader. Note the ears back, tense posture, and fluffed tail.  He was also caterwauling throughout the showdown.

Act now while supplies last

The Amazon website appears to indicate that my new book, Fixing U.S. International Taxation, is currently available for immediate ordering.  See here.  I have received my advance copies, but the official pub date is not until February 5.  Barnes & Noble is listing it, but just for pre-ordering.  On the Amazon website, you can actually click on "Look Inside" and see a fairly significant portion of the text.

If anyone finds that it's not currently available except as a pre-order, please let me know.

What is the "corporate income tax"?

Today's New York Times has an op-ed by Laurence Kotlikoff advocating abolition of the U.S. corporate income tax.  To make this revenue-neutral, he'd accompany it with increasing personal income tax rates.

Kotlikoff claims that "eliminating the United States' corporate income tax produces rapid and dramatic increases in American investment, output, and real wages, making the tax cut self-financing to a significant extent."  Ostensibly the "potential economic and welfare gains are stunningly large," even with an accompanying increase in personal income tax rates.

I looked quickly at the underlying paper by Kotlikoff and several coauthors, which is available here, and had the following concerns:

1) What exactly is the "corporate income tax" that we are repealing in his model?  While this is not entirely clear in the paper, perhaps he means the tax on income from capital that is invested in the U.S.  But this is a very different proposition indeed from the "U.S. corporate income tax."  At present, lots of domestic capital income is earned outside of corporate solution, and not just for tax reasons.. Also, lots of labor income, in an economic sense, can show up as corporate income because owner-employees don't have to pay themselves arm's length salaries.  Kotlikoff may view all this as merely a bunch of second order implementation details, but others might disagree.

More generally, it would be a huge mistake to think of repealing the existing corporate income tax as closely analogous in practice, even just in the steady state without regard to transition issues, to repealing the income tax and replacing it with a well-functioning progressive consumption tax.  The institutional details are just too different and consequential.  But once one recognizes this, one is stuck in the morass of niggling institutional details that make it harder to draw firm conclusions about anything relating to the corporate tax, especially from a very general and abstract model.  See my book, Decoding the U.S. Corporate Income Tax (paperback here, Kindle here), for discussion and explication of the existing corporate income tax system's lack of a coherent economic core.  This of course is not a defense of the existing system, but shows that it's harder than Kotlikoff may realize to determine what repeal of the system actually means.

 2) The paper appears to contemplate consumption and/or wage tax financing to replace the lost corporate income tax revenues.  By contrast, the op-ed speaks of higher personal income tax rates.

3) In the paper, the very large estimates of increased U.S. capital investment and welfare that are cited in the op-ed expressly depend on the lack of matching corporate tax reductions in other countries.  This appears quite unrealistic, especially if the behavioral response is as huge as the paper's results suggest.  The paper deals with the issue of matching corporate tax reductions around the world, which it unsurprisingly finds would significantly reduce the U.S. welfare gain.  Perhaps the op-ed should have acknowledged this point.

4) The paper and model appear to assume that the incidence of the U.S. corporate income tax falls almost entirely on labor, presumably because capital is highly mobile and labor far less so.  To the extent that this bottom line conclusion remains controversial, however, then to some extent the paper has risked assuming its conclusions.  (Not much of a surprise if U.S. workers were to gain from eliminating a tax that is assumed to fall substantially or entirely on them due to the effects of cross-border capital flows.)

Economic models with greater institutional detail than that by Kotlikoff et al do not invariably find this bottom line result to be clear.  (More precisely, some do, but others don't.)  For example, consider this paper, which finds, for state-level corporate income taxes, that  "firm owners bear roughly 40% of the incidence, while workers and land owners bear 35% and 25%, respectively."  States are even more by way of being small open economies than the U.S. as a whole, although admittedly labor mobility might be higher, not just absolutely but also relative to capital mobility, within the U.S. than across national borders.