Monday, December 11, 2017

Double taxation, non-taxation, and regulatory clean-up under the House and Senate tax bills

I've often commented, in the realm of international taxation, that focusing on "double taxation" can be a suboptimal way of understanding the tax burdens being imposed. E.g., I'd rather be taxed twice on the same income at 5% each time, than once at 35%.

But "double taxation" rhetoric can sometimes identify settings where the overall marginal rate might seem, upon closer examination, to be unduly high.

Now, in the Republican tax bills, we get "double taxation" via the disallowance of state and local income tax deductions. Again, that alone just means one should look more closely, rather than showing that it inherently must be bad. But it is surprising that the "double taxation" framework has been so little mentioned, given the common practice of decrying estate taxes as potentially leading to "double taxation" of income that was taxed when earned and then might be taxed again when it's transferred at death (albeit, of course, that the estate tax runs off value, not gain from a prior value).

So if one is "double-taxing" income via denial of the state and local income tax deduction, one should take extra care that combined tax rates don't go too high. But if there is anything at all that the Congressional Republicans are not doing as they rush these tax bills through, it's take care.

Now Richard Rubin has a nice article showing that the phaseout of passthrough benefits for certain professionals, plus taxes in a state like New Jersey can yield marginal rates, for certain taxpayers and in certain ranges, in excess of 100%. In other words, earn more and you end up with less.

Meanwhile, allowing complete non-taxation - zero ever (at least federal) on potentially unlimited amounts of income that one earns - appears to be a bedrock principle of both bills, despite its being rather hard to justify.

To my knowledge, a 2015 House bill offered the first instance in the history of the U.S. federal income tax in which a proposal to eliminate the estate tax was not accompanied by proposing curtailment of section 1014, the tax-free step-up in asset basis at death. But that was just a for-show exercise, given that President Obama would be certain to veto the legislation anyway. Now, in 2017, they've done it again, and apparently for real.

In 2001, by contrast, deferred repeal of the estate tax WAS accompanied by rule changes to make sure that people who had untaxed appreciation, and who now wouldn't be facing the estate tax, would at least not get the basis increase as well, and hence would not be able to eliminate permanently the prospect of any federal tax on huge gains.

Say I bought a Renoir painting for $1M, and due to the run-up in the art market its value has gone up to $100M. Under the House bill, the accretion and the value will never face any federal income or estate tax liability if my kids sell it after elimination of the estate tax. Under existing law, the same thing happens under the income tax, but at least the estate tax offers a kind of back-up (and anti-"double taxation" arguments have been deployed in support of the income tax result).

Some people thought that getting rid of the estate tax without addressing basis step-up, being so unprecedented and hard to justify, must just be an accidental glitch. But then the Senate bill substantially scaled back the estate tax without doing anything about it either. This despite their scrambling for revenue at the end, so they could purport to make the overall target. This suggests that it must have been deliberate. (And it's not hard to see why if one thinks in terms of what the donors would like.)

In sum, as the bills now stand, in certain very standard situations, there can be marginal tax rates in excess of 100% for some people, and of 0% for others.

One last bit about allowing the tax-free basis step-up at death is that it hugely increases the attractiveness of using corporations as a tax shelter through which one can pay just a 20% rate on both one's labor income and one's investment income. If the second level of tax is merely being deferred, the gambit may become significantly less appealing. But with a lower tax rate today, plus no tax in the future if you play your cards right, it's another way of having tax rates decline as one moves up the income scale (since the wealthy can more easily arrange this). And again, after what we've seen from both houses, I can only presume that this is an intended effect.

Will the Treasury attempt to address some of the worst tax planning gambits in the tax legislation, in cases where it can be argued that a given gambit must have been unintended? It's hard to say. What was intended will certainly be up for grabs here. Plus, if the IRS and Treasury leadership address enforcement in the same spirit that, say, the EPA reportedly does, you could have a setting where aggressive tax planning gambits, yielding untoward results, that arguably could be addressed through regulatory provisions and/or auditing, will deliberately be left alone, by policymaking fiat from up high.

Saturday, December 09, 2017

There is no reason why

Patricia Cohen, in today's NYT, has a nice piece discussing the pass-through rules. It's called "Tax Plans May Give Your Co-Worker a Better Deal Than You."

Opening paragraphs:

In most places, a dollar is a dollar. But in the tax code envisioned by Republicans, the amount you make may be less important than how you make it.
Consider two chefs working side by side for the same catering company, doing the same job, for the same hours and the same money. The only difference is that one is an employee, the other an independent contractor.
Under the Republican plans, one gets a tax break and the other doesn’t.

The article then explains the rule's regressivity, its penalizing being an employee for no known reason, its treating some professions more favorably than others for no known reason, and its strong inducement to artificial tax planning.

Somewhere in the middle, it quotes me as saying that the House version "might be the single worst proposal ever prominently made in the history of the U.S. federal income tax."

In fairness to the negative merits of the Senate version, it hadn't at that point been developed yet, so I couldn't compare the two.

I think any fair-minded reader will agree that the rest of the article, both before and after my quote, offers a lot of support for my statement. We think of the tax system as aiming to address efficiency, equity, and simplicity. The passthrough rule, in either version, unambiguously makes all three worse.

There is no rationale for the provision. To move towards equalizing passthroughs' tax treatment with C corporations? But C corporations face a second level of tax. Plus, business owners can simply incorporate if they like, without its inconveniencing them in any significant non-tax way.

For job creation? The chef who gets the low rate is a job creator, and the other isn't? Qualifying for the lower rate has no link to job creation.

It involves second-guessing of the market, based on what theory of market failure it isn't entirely clear. Why not let pretax prices guide appropriate investment and labor choices, as happens with neutral tax treatment? It's incoherent as industrial policy.

What defenses have been, or can be, offered for it? There really are none. Jared Walczak of the Tax Foundation is quoted as saying that the provision might make sense theoretically in a vacuum. But I take him to agree with me that the actual proposal is bad, as he follows this up by noting that it's difficult to distinguish between wage income and business income. I would add that it doesn't even make sense theoretically or in a vacuum.

Business income IS wage income insofar as it reflects the labor of the business owner. Anything else that we want the owner to do, such as reinvesting or whatever, can be addressed via rules aimed at that particular activity (e.g., expensing for capital investments, which the bills have on top of the passthrough rules).

What if employees save, and the bank loans the money to people who want to found or expand their businesses? That has less merit, because the Republicans in Washington know more than the capital markets?

The article mentions that the proponent's "idea is that these [the pass-through] businesses will reinvest those higher returns and stimulate growth."

If that's the goal, stimulate investment! Or is this actually just a call for redistributing money to people whom it is thought have a greater marginal propensity to invest? Then why not just give more money to rich people, without running it through the passthrough structure?

The balance of the article then gives us a taste for all the incredible "job creation" that the passthrough rules will ostensibly encourage. E.g., "staff lawyers on salary suddenly turn into partners" so they can get the passthrough rate. High-earning dentists do better still by becoming C corporations that are taxed at 20%. (The tax bill has no guardrails for that either.)

Friday, December 08, 2017

The Sex Pistols and tax "reform"

A reporter with whom I was chatting earlier this week about the problems with the pass-through rules asked me: Yes, but there must be reasons for having the rules, aren't there?

I replied: "To quote the Sex Pistols, 'there is no reason why.'"

I evidently assumed he meant reasons other than funneling giant tax savings to donors.

The Sex Pistols quote comes from their great anthem EMI, an exhilarating explosion in which they almost seem to accept leadership of a movement, despite all the positivity that would imply.

The reporter was surprised (although perhaps he shouldn't have been) to hear a law professor quoting the Sex Pistols. He said he might try to use it, but apparently it didn't fit in. So I trust I'm not scooping him here.

And so it goes, and so it goes, and so it goes, and so it goes. But where it's going, no one knows.

More games they might play

Here's some more that just occurred to me, and that I don't believe we included in The Games They Will Play. My apologies to anyone else who may have published about this already - I'd link, but haven't seen it.

Suppose a high-priced consultant of some kind produces memos, and/or creates videos embodying the advice. (Nothing fancy, just talking into the camera from one's desk.) Or suppose at least that the business could be done this way.

Might we now, with appropriate structuring, have sales of property (the memos and videos) by a pass-through business that deals in property, rather than the personal service business of consulting?  This is not about capital gains treatment (where it's an old issue, and where one would need to meet the holding period requirement to get the long-term rate).  It's just to take the thing out of being a personal service business, not one that sells property, for purposes of the pass-through rules.

If the consultant also still communicates his/her conclusions via conversations with the clients, do we need price allocation between the consulting payments and the sale of property?

And here's another, although it's probably more of a stretch. If the consultant works at home, and also rents the home out via AirBnB, might we have a business of  making money through use of the home in multiple ways, and hence that uses capital? Again, existing rules address versions of this type of admixture (e.g., the rules limiting home office deductions), but the idea here is different; it's just about changing categories in the pass-through rules.

Thursday, December 07, 2017

Newly published report on taxpayer game-playing under the Republicans' tax cut act

I am among the thirteen signatories of a report thas has just been published online, entitled "The Games They Will Play: Tax Games, Roadblocks, and Glitches Under the New Legislation."

Many thanks are due to the report's lead drafters, who were Ari Glogower, David Kamin, Rebecca Kysar, and Darien Shanske. It draws on many people's analyses, including not just that of other signatories, such as me, but also numerous non-signatories who have helped to advance the rushed public conversation.

Evidently, the notion of public service, based on caring disinterestedly about the tax law's quality and effects, isn't dead in the tax academy and the tax bar, even if it appears to need a respirator up on Capital Hill.

Here is the report's Executive Summary:

This report describes various tax games, roadblocks and glitches in the tax legislation currently before Congress.

The complex rules proposed in the House and Senate bills will allow new tax games and planning opportunities for well-advised taxpayers, which will result in unanticipated consequences and costs. These costs may not currently be fully reflected in official estimates already showing the bills adding over $1 trillion to the deficit in the coming decade. Other proposed changes will encounter legal roadblocks, that will jeopardize critical elements of the legislation. Finally, in other cases, technical glitches in the legislation may improperly and haphazardly penalize or benefit individual and corporate taxpayers.

This report is not intended as a comprehensive list of all possible problems with the drafting and design of the House and Senate bills. Rather, this report highlights particular areas of concern that have been identified by a number of leading tax academics, practitioners, and analysts.

In particular, the report highlights problems with the bill in the following areas:

Using Corporations as Tax Shelters

If the corporate tax rate is reduced in the absence of effective anti-abuse measures, taxpayers may be able to transform corporations into tax-sheltered savings vehicles through a variety of strategies. For instance, at the most extreme, it may be possible to shield labor income in a C-corporation so that it faces a final tax rate of only 20%.

Pass-Through Eligibility Games

Taxpayers may be able to circumvent the limitations on eligibility for the special tax treatment of pass-through businesses. For instance, under the Senate bill, many employees—such as law firm associates—could become partners in new pass-throughs and potentially take full advantage of the special tax treatment.

Restructuring State and Local Taxes to Maintain Deductibility

The denial of the deduction for state and local taxes will incentivize these jurisdictions to restructure their forms of revenue collection to avoid this change. This could undercut one of the largest revenue raisers in the entire bill.

International Games, Roadblocks, and Glitches

The complex rules intended to exempt foreign income of domestic corporations from U.S. taxation present a variety of tax planning and avoidance opportunities. For instance, one provision would encourage sales of products abroad, only for those products to be sold right back into the United States. Furthermore, several of these rules are likely to be non-compliant with both World Trade Organization rules for international trade and our network of bilateral tax treaties. Some of these rules also create perverse economic incentives, like advantaging foreign over domestic manufacturers.

Arbitrage Money Machines

The variety of tax rates imposed on different forms of business income in different years invite arbitrage strategies, whereby taxpayers can achieve an economic benefit solely based on the timing and assignment of their income and deductions.

Other Glitches

Other glitches in the proposed bills would haphazardly penalize taxpayers. For example, the reintroduction of the corporate AMT at the 20% rate in the Senate bill would vitiate key tax incentives and the basic structure of the international reforms. The proposal in the House bill to tax capital contributions to entities could penalize taxpayers for no justifiable reason.
_______________________

Again, the report is available here.

Monday, December 04, 2017

One way to improve the tax bill (although it would still be awful)

My view of both tax bills that now await a conference is that they combine making revenue and distribution much worse with reducing the efficiency of the tax system and greatly increasing its complexity for high-income individuals, who will be absolutely swimming in new tax planning opportunities. It also represents a historically unprecedented use of the federal income tax system as a targeted weapons system for distributing favors to friends (beyond just using "rifleshot" special exceptions for one or two taxpayers, although we have those too) and, let's call it less favorable treatment for non-friends.

That said, there is one way that one aspect of the harm could be made less bad, although they won't be taking me up on this. A clear goal of the legislation is to ensure that special friends among the super-rich pay lower marginal rates than people in the upper middle class. I wouldn't dignify this with the label of "belief about fair distribution," since, for example, high-paid CEOs of publicly traded companies don't appear to be in the special friends group.

The aim, rather, is that very rich people they like, in industries they like, should pay lower marginal rates than those in the upper middle class or the less-favored super-rich.

But let's suppose they were willing to generalize, in a more principled way, their belief that very rich friends should pay lower rates than people in the upper middle class. Suppose they were willing to apply this belief to all very rich people, on a neutral basis within that group.

Then there would be a mechanism for reducing the tax bill's inefficiency and encouragement of tax planning, without doing any overall harm either to revenue or to distribution.

It would be a simple four-step process: (1) eliminate the passthrough rules, (2) address the use of corporations as a tax shelter, via the under-payment of owner-employee salaries and the "stuffing" of corporations with investment assets, (3) eliminate the tax-free step-up in basis at death, which greatly worsens lock-in for appreciated assets and ensures that huge profits enjoyed at the top will never be taxed at all, and (4) lower the top rate as much as you can given these changes, without sacrificing overall revenue or changing overall distribution. We might then have an overt, and perhaps significant, decline in marginal tax rates at the top.

This would eliminate the inefficient industrial policy and inducement to ridiculous tax planning that the current structure has, without making either revenue or distribution any worse than they are already. It would also amount to an honest statement of the actual distributional policy that evidently motivates the tax bills, insofar as there is a policy beyond that of rewarding donors and friends. And, for what it's worth, it would avoid treating the super-rich unequally (special friends better than the rest).

It would be interesting to know just how much rates at the top could decline in this scenario. But we know they won't do it, for at least 3 reasons: (1) lack of concern about the structural and tax planning problems that the bills are causing, (2) a preference for dishonestly concealing the actual distributional policy (hence all the lies about this being a "middle class tax bill"), and (3) the fact, that among the super-rich, they want to direct the largesse at their special friends in particular.

Saturday, December 02, 2017

Calling all tax "leasing" experts


Today's magic word of the day, if the final tax bill has either of (a) the lower pass-through rate (it will) and (b) the one-year corporate rate cut delay (who knows), is LEASING. There will be a lot of "leasing" going on, take my word for it.

UPDATE / CLARIFICATION: A friend has forwarded to me an interesting analysis of the tax bills' effect on equipment leasing, which has pluses and minuses that are still unknown given uncertainties about the final legislation. Limiting interest deductibility, for example, could worsen the tax analysis of equiment leasing in some scenarios.

I didn't mean to address, in the above comment, how actual leasing in the economy would be affected by the tax legislation. Leasing in that sense is a finance method for particular actual & substantive transactions, and I haven't attempted to analyze how it works out against other methods. Obviously there may be tax reasons for using leasing, rather than something else, as one's formal structure, but (at least in the standard case) it's a function of actual business deals, typically involving new investment.

What I meant by "leasing" in the above, and the reason I used scare quotes, is because I meant to refer to pure tax planning transactions - such as:

1) One's left hand "leasing" something to one's right hand. An example would be a law firm, under the House bill's passthrough bills, forming a real estate partnership to lease the building to the service partnership,

2) Sale-leasebacks to transfer title to taxpayers that can better use the expensing deductions, and

3) Under the Senate bill, the use of leases and subsequent sale or purchase option to take maximum advantage of the 35% corporate rate in 2018 versus the 20% rate in 2019.

In sum, leasing may or may not be helped by the tax legislation - but "leasing" WILL be helped.

Friday, December 01, 2017

What could a reasonable Republican-ish tax reform have looked like?

Now that the tax bill is temporarily paused due to deficit issues - although I'm still expecting it to go through, and probably sooner rather than later - it's a good time to ask, not so much what went wrong as what could have gone right, at least in an alternative universe where our political system was better-functioning. And in particular, I'm thinking of an alternative universe in which, say, the beliefs of reputable conservative economists, rather than reputable liberal economists, had particular influence with policymakers. (I say this due to a number of legitimate disputes about good policy that I will mention without trying to resolve here.)

The lesson of the actual process, alas, is that bad people with bad motivations, acting in haste to avoid deliberation and accountability, are going to do bad things. Also, being ignorant seems to have some disadvantages. But even so, some of the ideas they started with, and which are to a degree in the proposed legislation, would have at least arguable merit if done differently.

One more bit of throat-clearing here: I think we academics have learned something about business tax reform - or. to avoid that loaded and misused term "tax reform," desirable business tax changes that respond positively to changed circumstances since 1986.

My sense of the predominant consensus among us several years ago is that it viewed the corporate (or business) and individual levels as too intertwined for one to be changed significantly without also addressing the other.  But then some of us got impatient. The business level of current U.S. income taxation is so bad, the view grew, that can't we do something about it without waiting for the whole thing to improve?

In principle, this view could be either right or wrong. It's a judgment call. Obviously addressing the whole thing would be better, but might it still be worth trying to hit a double instead of a homer?

I am thinking that the answer has turned out to be: No. A key problem I (and others) had with the destination-based tax was that doing it apart from addressing the individual side threatened to cause real problems. But politics has also strengthened the case for No.

The movement for a lower pass-through rate, which (as I've argued in earlier blog posts) might end up being the single worst structural change in the history of the U.S. federal income tax, shows how politically intertwined the corporate/business and individual levels are. But in an earlier version of the problem, people came to realize that paying for lower corporate rates through income tax-style base-broadening would hand the pass-through sector a huge tax increase that, whether or not it was good policy, was certain to be politically unfeasible. Same problem from the opposite angle.

OK, getting at last to this blogpost's title, what could a reasonable Republican-ish tax reform have looked like? Here are some main points:

1) Lower corporate headline rate, with base-broadening offsets. But note two different types of offsets: those that simply get rid of industry-specific tax breaks, and those that make our system more of an income tax and less of a consumption tax. It's easier to reach intellectual consensus in favor of the former than the latter. But doing just the former wouldn't pay for much of a rate cut at all, on a revenue-neutral basis that ought to have remained the target given long-term fiscal issues.

Lower still, thus losing revenue? Maybe, if there are alternative revenues sources - e.g., VAT or carbon tax. (The key to the destination-based tax, of course, is that it tried to smuggle in a VAT by calling it something else.) But if the corporate or business rate is lower than the individual rate, and you still have an income tax at the individual level, a bunch of further steps are desirable. One is to try to limit the extent to which the benefits of the lower rate reach old investment. It should just be for new investment. But the politics on this are backwards - inefficient transition gain is exactly what the donors want.

Also, if the corporate or business rate is lower than the individual rate, one should think about shifting more taxes to the owner/shareholder level, and also about addressing the use of corporations as a tax shelter via the underpayment of taxable compensation to owner-employees. (The lower passthrough rate gets this completely backwards - extending preferential rates to labor income of owner-employees, despite the supposed guardrails, and despite the second level of corporate tax, and thereby inflicting punitive relative treatment on employees plus insoluble line-drawing problems.)

2) Move towards expensing - Once again, there is dispute about this. E.g., just limiting it to my past or future Tax Policy Colloquium co-teachers, Alan Auerbach vs. Lily Batchelder. But there is a case for expensing, so long as it's accompanied by sufficiently addressing interest deductibility, so taxpayers can't get a net subsidy by combining consumption tax treatment of the outlay with income treatment of the interest expense.

But implementation of expensing, when there is still an income tax at the individual level, requires further thought about the coordination between business and individual taxes. Plus it causes big problems when tax rates change.

I've been pointing this out with reference to the idiotic Senate Republican proposal to start expensing in 2018 and the lower corporate rate in 2019. (Hence, deducting $100 in 2018 at the 35% rate, in order to earn $90 in 2019 at the 20% rate, makes money after-tax.) But it's a much broader and more general problem. Indeed, I gather that the Senate Republicans are struggling with the other side of it right now, as businesses have complained to them (making a conceptually correct point) that they would lose from expensing outlays at a 20% rate and then including the returns at, say, a 22% rate.

3) International - Here there is actually a bit of free money available, in an efficiency sense. (Not free politically or distributionally, however.) Two aspects of it. First, deferral makes no sense whatsoever. I have long called it a "ceasefire in place" between the warring pro-worldwide and pro-territorial viewpoints. No one with any sense favors deferral; the issue is "compared to what." Immediately taxing US companies on their foreign profits at the "correct" rate is unambiguously better than deferring the tax, which would then ultimately depend on the tax rate in the repatriation year plus the value of foreign tax credits.

But what is the correct rate? Oops, that's the hard part, and I certainly don't mean to rule out the possibility that, at least in some instances, it might be zero. Due to the complex nature of the underlying issues, which I've tried to unpack (without resolving definitively) in a number of academic articles, we don't know what the correct rate is, or how it should vary with particular details of the foreign source income that is at issue. (E.g., what is reported as tax haven vs. other income.) A further problem is that there's no clear consensus about the optimal amount of profit-shifting by US and foreign companies that are operating in the US. It's not necessarily zero, since they may be more mobile than other businesses. That undermines figuring out how rigorous the anti-profit-shifting rules should be, especially if some of our tools work better against US than non-US companies but we don't inherently want to treat the two differently.

Still, the problems with international deferral means that something better ought to be possible. Plus, it is clear that a deemed repatriation of past earnings that US companies have stashed abroad would not only raise revenue (within the budget window, no less) but be desirable in efficiency terms. E.g., it reflects past decisions, and might reduce the anticipatory incentive to engage in further future profit-shifting that exceeds what we determine is the optimum.

So that's in a sense free money in budgetary terms, except that the rate imposed could in principle be too high, plus the companies aren't going to like it unless the rate is very low.  (If too low, it's in effect another repatriation holiday even if mandatory. After all, a mandatory deemed repatriation is equivalent to a voluntary holiday for anyone who would have taken advantage of the holiday anyway.)

Obviously this falls far short of saying what a principled Republican-ish tax reform could have looked like. But it could have had a lower corporate rate, properly addressing the difference between corporate and individual rates, a new revenue source,, something more like expensing but with reduced interest deductibility and due sensitivity to tax rate changes, and something in international, where there are reform plans out there that could have been consulted.

Sounds pretty vague, I know, but with good people who cared about governance, a year or two of bipartisan deliberations might have led to something that principled conservative economists could endorse without descending to dishonest hackery, and that principled liberal economists could agree had significant merits even if they would do some of it differently.