The Return of Capital

Thomas Piketty, Capital in the Twenty-First Century (2014).

If I had nothing more specific in mind, it would verge on being trite–or perhaps achieve triteness with margin to spare–to identify Thomas Piketty’s Capital in the Twenty-First Century as a 2014 publication worth noting at Jotwell. At least as of early spring, the reviews–predictably laudatory from the left, and cautious or critical from the right–have been sprouting like dandelions in Central Park, and there have also been regular (indeed, almost daily) features about Piketty and his opus, appearing in periodicals of all kinds. Most readers no doubt already know that Piketty has combined a compilation of groundbreaking empirical research about wealth distribution in multiple countries over the last few centuries with an important and provocative thesis about the likely (or at least a possible) future.

Piketty argues that high-end wealth concentration has a tendency to keep on augmenting itself in modern capitalist societies, at least for an indefinite time. He views the mid-twentieth century’s “Great Easing” of this process as reflecting distinctive and anomalous factors that make it unlikely to be repeated. He attributes it mainly to the era’s enormous shocks–in particular, the Great Depression and two calamitous world wars–and secondarily to the pursuit of economic and regulatory policies that deliberately sacrificed neoclassical market efficiency in pursuit of other objectives, or else in response to concerns about market failure that came to be dismissed with the rise of such political leaders as Ronald Reagan and Margaret Thatcher.

The catchphrase that everyone has come to know is “r > g”–that is, the rate of return to capital exceeds the growth rate of the economy, an empirical relationship that he views as highly resilient during most periods and as inevitably accentuating economic inequality given how the ownership of capital is concentrated at the top. He views this as leading to political plutocracy or oligarchy, and to the rise of a “rentier” society like that depicted in the works of Jane Austen and Honore de Balzac, in which potential returns to labor are dwarfed by those to inherited wealth. He also argues that rising wage inequality in the U.S. driven by the rise of managerial compensation, both (a) reflects corporate governance failures that deprive the amounts earned at the top of any strong relationship to marginal private (much less social) value provided, and (b) will end up mainly fueling, rather than significantly modifying, the relative rise of capital income over labor income.

Again, this much is already well-known and being vigorously debated. What I want to add here concerns the sizeable, but as yet little discussed, disjuncture between the frameworks used by Piketty on the one hand, and in much of the last three decades’ tax policy literature on the other hand. One can see the disjuncture on both sides. Piketty, for his part, appears not to have drawn much from, say, the literature concerning optimal income taxation or the income tax versus consumption tax debate. On the tax policy side, many lawyers but also economists have tended to view vertical distribution issues through a very different lens than the one he employs. It is important to evaluate the extent to which the different lenses are inherently competing as opposed to complementary, and in either case to evaluate their relative usefulness.

The main disjuncture relates to Piketty’s use of two key concepts: “capital” and the “return to capital.” While I have already noted the role that both play in Piketty’s account of the past and our possible future, how do things differ in, say, the legal academic literature concerning optimal income taxation and the income tax versus consumption tax choice?

“Capital,” to which Piketty assigns such a central role, has in a sense been banished from much recent tax policy literature. We know that, while deployed jointly with labor in economic production, it is considerably more mobile. But we sometimes think of it as earning a normal, real rate of return that is little distinguishable from zero. This conclusion reflects teasing out, as conceptually distinct from the normal rate of return, the elements of risk-taking and of inframarginal returns that may generally be labor income in substance (e.g., the entrepreneurial profits of a Bill Gates or Mark Zuckerberg). Thus, the importance of “capital” in the Piketty story raises questions that need further examination.

Turning from the macro level of economic production to the micro level of individual choice under scarcity, James Mirrlees’ foundational optimal income tax model does not even have capital. Instead, it is a one-period model in which people earn labor income and simultaneously spend it on market consumption. While the model’s omitting the element of time is a conscious simplification, adding it back can make surprisingly little difference to the analysis. Suppose we think of saving, which leaves one with capital to invest, as merely deferred consumption in what is mainly a lifetime income (and consumption) model. Even adding inheritance may not change things very significantly. Where not purely accidental (reflecting under-annuitization), it may be thought of as reflecting altruistic or warm-glow utility functions in which bequests yield bonus utility–that of the donor and the donee alike, from the former’s enjoying the prospect that the latter will derive enjoyment from spending the inheritance. Once again, we are clearly very far here from Piketty’s world.

Finally, how can one reconcile Piketty’s historical evidence, showing r > g, with viewing the normal real return to saving as scarcely distinguishable from zero? Here, the key point is that Piketty is measuring historically observed ex post rates of return, without addressing ex ante expectations or the risky versus risk-free element.1 By contrast, recent legal literature addressing the risk issue frequently assigns a large component to risk, viewed as conceptually distinct from the “normal” return to saving, with the breakdown being the two being evaluated based on the observed rate of return on specific, apparently risk-free assets, such as short-term Treasury notes. Here too, the relationship between the two literatures leaves us with much to think about.

One last point that could possibly lead to a narrowing of the gulf is as follows. Suppose one agrees with Piketty’s empirical prediction that, barring some disruption to observed trends, high-end wealth inequality will keep on growing significantly. It is a separate question whether one should consider this a problem. However, there is plenty of room, including in a purely utilitarian framework, to consider this highly regrettable (or at least potentially so) for reasons that are not limited to observing that poorer individuals might tend to have higher marginal utilities for a dollar than richer individuals. For example, one might believe that extreme high-end wealth concentration can have broader adverse effects on individuals’ welfare, including through its effects on the functioning of various social and political institutions. If one accepts all this, then Piketty’s work might be taken as suggesting that saving, and high ex post rates of return on saving (even if reflecting risk), may have significantly negative net externalities, even if they might also yield positive externalities of various kinds. This, too, however, serves merely to suggest possible directions for further inquiry, the outcome of which should not be regarded as preordained.

Editor’s note: For other Jotwell reviews of Thomas Piketty’s Capital in the Twenty-First Century see:

  1. Piketty recognizes that observed capital income may have an intermingled element of labor income, when entrepreneurs work for themselves, but argues that as an empirical matter this issue has only limited importance. []

Thomas Piketty’s Book Is Masterful and Important, but Ultimately a Sideshow

Thomas Piketty, Capital in the Twenty-First Century (2014).

By now, it seems that everyone has heard of the new tome from French economist Thomas Piketty. Capital in the Twenty-First Century continues to top The New York Times Bestseller list for hardcover non-fiction, which hardly seemed likely for a book that is mostly built on an analysis of European and American tax records over the last century or two.

Piketty’s book deserves all of the plaudits that it has received. It is a masterpiece of economic analysis, advancing our understanding of wealth concentration in the world’s richest democracies, and offering a provocative forecast of the future of inequality in the U.S. and elsewhere. Even the most trenchant reviews of the book that take a negative tone, such as the economist James K. Galbraith’s essay in Dissent, rightly conclude that Piketty has made an important contribution to knowledge.

For tax policy scholars, Piketty’s book would seem to be especially interesting, because he takes a strong and provocative stand in favor of wealth taxation. Although one can say that Piketty’s call for wealthy countries to work together to tax wealth is utopian (which Piketty readily admits), the point is that he has made the intellectual case to rein in growing inequality by confronting it head on. If wealth concentrations are a growing problem (and they are), then the best policy response is to reduce wealth concentrations. Taxing wealth is an obvious place to start.

This book is fascinating and ground-breaking because Piketty shows that the concentration of wealth in the U.S. (and France and the U.K.) has recently returned to historically high levels, with the wealthiest citizens today finding themselves in the same rarefied territory as their forebears in Belle Epoque France (from the 1870’s through WWI) and the U.S. Gilded Age of the Roaring Twenties.

Piketty then notes that wealth concentration can become essentially irreversible, if the return on owning wealth (interest rates, broadly conceived) is greater than the growth rate of the economy overall. That is, if the people who own the wealth can do nothing but sit back and watch their wealth grow at, say, 5% per year, while the rest of the economy grows at 3% per year, then working people (whose wages are ultimately limited by the economy’s growth rate) will fall further and further behind the idle rich.

The strong claim in the book is that this future does, indeed, await the U.S. and Europe. This is especially important, because it contradicts the feel-good conventional wisdom that a growing economy is good for everyone, rewarding people for their hard work. But if the economy is hard-wired such that income from working will inevitably shrink relative to income from being already wealthy, something is seriously askew. Piketty claims to find some empirical regularities that make the growth of this kind of “patrimonial capitalism” inevitable. Adding in the sensible observation that wealthy people can use their wealth in the political arena to change policies to their benefit, Piketty concludes that it is essential to prevent the onset of patrimonial capitalism before it becomes permanently entrenched.

As the title of this essay suggests, however, this insight is not a game-changer for tax policy. Why not? If Piketty is right, then all he has done is to strengthen the case for taxing wealth, especially inherited wealth, to prevent the world from become ruled by family dynasties. But his case essentially amounts to the argument that things will get much worse over time, unless we do something about it, so we would be wise to get started sooner rather than later. If that were the only reason to tax wealth, however, then even liberal redistributionists would have a hard time summoning a lot of energy to make Pikettian tax policy the centerpiece of their political agenda.

And if Piketty is wrong, so what? Maybe there is some long-run hope that the concentration of wealth is not inevitably going to get worse, because labor income could grow faster over time than investment income. But merely because it is not inevitable does not mean that it could not still happen. Moreover, executive salaries and other high-end earnings count as labor income, not returns to capital, so one could easily see a non-Pikettian future with labor’s share of the economy growing, but with the distribution of labor income itself becoming ever more skewed toward the wealthiest earners. Indeed, some people who think that they are scoring points against Piketty by pointing out that the U.S. does not (yet) look like a patrimonial capitalist economy are, at best, simply arguing that the extremely high income and wealth concentrations in the U.S. are the result of highly unequal wages and salaries, not inherited wealth.

In short, one could believe in a redistributive tax policy regime without having any opinion about Piketty’s book. The extra “oomph” from Piketty’s book, for tax policy purposes, at most amounts to a reminder that wealth accumulation can gain momentum over time. That is not to be ignored, but as I argued above, the extra policy impact is minimal.

The reason for the frantic response to Piketty’s book from conservatives, including full-on red baiting, is that the book has somehow captured the broad unease that people have begun to feel about rising inequality. With everyone from Pope Francis to President Obama having recently bemoaned the concentration of income and wealth in the hands of the elite few, people can now point to Piketty’s book to support the idea that there is something deeply wrong about all of this.

But without Piketty’s book, we would still have more than enough evidence that we should be increasing taxes on the rich. In my Jot last year, I endorsed a paper by Emmanuel Saez and Peter Diamond, which summarized research that they and others (including Piketty himself) have published over the last decade or so. That research shows that both income and wealth can be taxed, even at high levels for the richest people, without the bad economic consequences that anti-tax ideologues take as gospel.

In other words, Piketty’s book is not all that important for tax policy, because Piketty’s other work (and that of his frequent co-authors) has already changed the debate about tax policy. We are now living in a changed world, where we know that policies to redistribute income and wealth can decrease inequality while improving the economy. If it took the publication of Piketty’s book to mobilize politicians and the public to do something about inequality, so be it. But we should not imagine that the case for redistribution rises and falls on the book’s predictions. Inequality is the defining challenge of the twenty-first century. Now, we just need to do something about it.

Editor’s note: For other Jotwell reviews of Thomas Piketty’s Capital in the Twenty-First Century see:

A Lawyer with a Candlestick in the Conservatory: The Perpetuities Whodunnit

Grayson M.P. McCouch, Who Killed the Rule Against Perpetuities?, 40 Pepp. L. Rev. 1291 (2013).

Ding, dong, the Rule Against Perpetuities is dead. Well, in about half of all states. No longer must property interests vest within “lives in being plus twenty-one years.”  Wealthy individuals can put their money in trust forever. Even better, when that trust is created in a state without an income tax, and the trust assets never become included in the estate of a beneficiary, assets transferred to a perpetual trust remain … perpetually tax-free. What is the explanation behind the rush among states to repeal the RAP, beginning in the mid-1990’s? Professors Robert Sitkoff and Max Schanzenbach, among others, have pointed to the generation-skipping transfer tax as the engine driving repeal. Other theories include settlors’ desires for post-mortem control or creditor protection for beneficiaries. Enter into the conversation Grayson M.P. McCouch with his concise and well-written article, Who Killed the Rule Against Perpetuities? McCouch argues that the repeal of RAP is as much the work of bankers and lawyers as it is of any tax law.

McCouch begins his essay by looking at the use of perpetual trusts before and after the enactment of the generation-skipping transfer tax (and its $1 million exemption) in 1986. Prior to 1986, it was possible to create a perpetual trust in Delaware, Wisconsin and Idaho, albeit via different mechanisms or legal exceptions. Yet those states did not have a lion’s share of the trust business, which McCouch attributes to settlors’ ability to achieve objectives within the perpetuities period of their chosen local jurisdiction and a sense that the tax benefits of creating a trust in Delaware, Wisconsin or Idaho were “incremental” at best. After 1986, the generation-skipping transfer tax inspired a search for ways to avoid technical problems that could arise even in the existing perpetual jurisdictions. (McCouch explains the “Delaware tax trap” problem with such clarity and elegance that the article is worth reading for that single paragraph alone.)

McCouch goes on to ask the more difficult question of why the period of rapid perpetuities reform did not begin until 1995 with Delaware’s repeal of the rule, almost 10 years after the enactment of the generation-skipping transfer tax. He suggests that only with the economic boom of the later 1990s did lawyers and bankers start to market perpetual trusts in a way that appealed to the dynastic aspirations of the newly rich. He observes, “Perpetual trusts, like other upscale goods and services, are sold at retail to well-heeled consumers through appeals to vanity, anxiety, and ambition, as well as tangible financial returns.” McCouch suggests that bankers and lawyers—not their clients or the host jurisdictions—are the real beneficiaries of the repeal of the rule against perpetuities.

For readers who are interested in the relationship between and among tax law, legal reform and professional culture and change, this article provides much food for thought. Many states that have repealed the rule against perpetuities have also abolished income taxation of trusts and their beneficiaries. For that reason, even states with a booming trust business may not receive any direct tax revenue from it. But the ancillary effects of increased trust business—more jobs created in that state—should not be underestimated. It may be that some lawyers and bankers have benefitted handsomely from perpetuities reform, but so has that same reform given rise to a new cadre of supporting professionals who pay taxes and spend their paychecks in those states. McCouch’s article undoubtedly will serve as the inspiration for additional scholarship in this area.


The Influence of Experts

Mai’a K. Davis Cross, Rethinking Epistemic Communities Twenty Years Later, 39 Rev. of Int’l Studies 137 (2013).

Why do certain ideas gain traction in policy debates? Regardless of one’s field of study, this question cannot be ignored. The challenge is where to look for answers. The 2013 article by political scientist Mai’a Davis Cross, Rethinking Epistemic Communities Twenty Years Later, is one new and relevant resource in this quest. For more than a decade international tax scholars have drawn on the work of international relations (IR) theory and scholarship. In part, this attention by the tax community was out of necessity. Although it was apparent that international tax policy was subject to and the product of the same basic forces animating the classic subjects of IR study (e.g., military, trade, and environmental policy) tax policy formation traditionally has received scant attention from this branch of political science research. Yet the ideas being developed in IR theory would prove important to a serious and sophisticated understanding of “international tax relations.” Thus, international tax scholars began looking across the divide of research fields to consider the value added from the IR theory work of political scientists such as Cross.

Rethinking Epistemic Communities emerges from one broad strand of IR theory, cognitivism, which explores how we know what we want, what we value, and what we seek. That is, even if much of international relations activity concerns the use of power and/or bargaining games to secure “desired” outcomes, how do countries and other key actors determine what they want? Certainly in some cases the parameters of what a country seeks to achieve may seem relatively clear, but in many others the outcome or at least its particular form, is less obvious. Under the broad umbrella of cognitivist theory, scholars devoted increased attention to the concept of “epistemic communities”– the idea of a “community of experts” who through their own internal standards might develop some measure of “consensus” on an issue. Because of the recognized special knowledge of this community, the consensus ultimately would be influential in shaping outcomes sought by decision. The prototypical epistemic community was a science “community” coalescing around a solution to a problem that would form the basis of international agreement among a number of states. But international tax policy seemed a fertile ground for exploring the potential influence of epistemic communities. Who is formulating ideas of successful or sensible international tax policy? When and how do they achieve credibility? Does the epistemic community model fit?

International tax scholarship has begun to explore these ideas a little, but as one of those interested in the potential for this line of inquiry, I have been eagerly awaiting more guidance and input from the IR literature. However, despite the fact that these ideas were actively introduced into the IR literature in the 1990s, subsequent years have generated less scholarship than might have been hoped or anticipated. Against that backdrop, Rethinking Epistemic Communities offers hope and guidance for a renewed exploration of this concept. As Cross articulates, the study of epistemic communities, particularly in the context of transnational global governance highlights how both state actors and the increasingly important non-state actors are affected by epistemic communities and the constructions of norms, goals, and shared understandings. She acknowledges certain criticisms of the concept but sees them not so much as a constraint on further research but rather a road map of the important questions that future scholarship should address.

For readers already familiar with the topic, the article provides a great contemporary snapshot of the current debates and a thoughtful consideration of next steps. For those newer to the ideas of epistemic communities, the article offers a concise but contextualized overview that goes beyond mere definition and example to offer perspective on the role and value of continued exploration of these issues. And finally, for all readers Cross clarifies some enduring misconceptions (e.g., epistemic communities were never envisioned as exclusively the domain of science; expert influence is not synonymous with ideal policy recommendations) and presents a valuable compilation of the significant scholarship on epistemic communities of the past decade. Every scholar should be concerned with the origin of influential ideas and policy recommendations in the global arena even if these questions do not take center stage on the research agenda. Cross’s article proves a useful entry point into the current study of epistemic communities.


After the Financial Crisis

Richard Eccleston, The Dynamics of Global Economic Governance:  The Financial Crisis, the OECD and the Politics of International Tax Cooperation (Edward Elgar, Cheltenham, 2012).

The breadth of global tax evasion has made public headlines and brought attention to the initiatives of the Organisation for Economic Co-operation and Development (OECD), alongside the G20 and other international bodies.  As Richard Eccleston reports, “the sheer magnitude of the threat that international tax evasion poses, denying governments approximately $250 billion per year – more than 15 times the sum spent on humanitarian aid globally in 2011 – ensures that the issue is gaining prominence on the international political agenda.” (P. 33) When taxpayers evade their obligations, the world suffers.  How could anyone not be gripped?

The Dynamics of Global Economic Governance:  The Financial Crisis, the OECD and the Politics of International Tax Cooperation is a welcome addition to the literature on the regulatory responses to international tax evasion, authored in the light of the global financial crisis.  Richard Eccleston, a political scientist in Tasmania, shifts the typical legal scholar’s lens from the legal frameworks that facilitate tax evasion to a careful and insightful exploration or the role of political actors in facilitating tax cooperation in response to that evasion.  The work is supported by interviews with more than 40 national tax officials, business and NGO representatives, OECD and UN staff.

From a political science perspective, I understand that the work distinguishes itself from prior contributions because Eccleston argues that the financial crisis created the bench from which the OECD was able to successfully agenda-set and promote international tax cooperation among the G20 leaders.  This discovery runs counter to at least some of the previous political science and international relations work in the area, which has found only limited evidence that international organisations, like the OECD, shape national policy.

Global Economic Governance is written for tax junkies.  It is shot through with detail, carefully crafted, and densely written.  For those with a mild interest in the area, the chapter to spend time on is the first one, and most specifically the section that details the strategies used in international tax evasion: private banking, mass-marketed tax schemes, opaque corporate structures, shell entities, trusts, rules that obscure real ownership, methods of disguising real corporate ownership, and exempt entities.  This reads like the stuff of a good (or perhaps average) Tom Cruise movie: nevertheless, it is daily fare for those who seek to avoid tax liability around the world.

Chapter 2 provides a sophisticated account of the different methodological approaches and theories that could inform this kind of political science work and ultimately details the theoretically-informed narrative method Eccleston has embraced, which uses a combination of deductive and inductive strategies to assess theories of international regime change.

For those who like tax policy, dig in from Chapters 3 to 6.  Those chapters start with a review of the OECD’s Harmful Tax Competition initiative.  In its early instantiation, that initiative sought to alter the practices of countries with no or only nominal taxes, no effective exchange of information, no transparency, and where no substantial economic activity was required for an economic actor to be associated with the jurisdiction.  Those early objectives were altered and eroded as the project evolved.

As someone who loves tax, I’ve spent many a dinner debating the Harmful Tax Competition initiative: Was that project effective?  Could it have been?  What role did the different OECD country-actors (especially Switzerland and the United States) play in the adjustment of the aims of the initiative over time?  What role did that initiative play in the push to information exchange and transparency that followed the financial crisis in a new wave of proposals (tax transparency) from the OECD?

Chapters 3 through 6 weigh in on those questions, and others.  Eccleston concludes that despite what he considers the failure of the OECD’s early efforts, its work following the financial crisis was instrumental in shaping national policy responses.  The OECD served as an advocate for the G20 to endorse tax transparency measures.  More fodder for those of us who like to debate these matters that are so essential to global tax governance.

In Chapter 6, the last substantive chapter, Eccleston focuses on the potential of tax transparency initiatives, the OECD’s post-financial-crisis focus. The objective of promoting tax transparency, at least in terms of the OECD work, has found its chief realization in the proliferation of bilateral tax information exchange agreements.  I agree entirely with Eccleston’s less optimistic assessment of the potential effectiveness of those agreements.  Without automatic information exchange, it’s hard to imagine that the scope of international tax evasion will be reduced.  That said, the OECD’s most recent move (on February 13, 2014) to release a model Competent Authority Agreement and Common Reporting Standard for automatic exchange of financial account information might provide some very modest grounds for cautious optimism.  Eccleston’s work suggests that it may get some traction.

If you love tax law and policy, Global Economic Governance should be on your reading list.  Don’t expect light reading, but do expect to come away with a richer sense of the contributions political scientists can make to our understanding of the tax evasion challenges ahead and the potential role of institutional actors, for better or worse.


There’s Math for That! Delta Value and the Constructive Sale Rules

Thomas J. Brennan, Law and Finance: The Case of Constructive Sales, Ann. Rev. Fin. Econ. (forthcoming 2013) available at SSRN.

Tom Brennan’s recent paper, Law and Finance: The Case of Constructive Sales explains that constructive sale guidance and case law fail to take account of volatility.  To fix the omission, Brennan explains, use the delta value of the constructive sale transaction relative to the underlying asset to determine how close the transaction is to a sale.  Reg writers, take note.

When do you own something, or more to the point, when have you sold it?  In tax terms this presents the question of realization.  And on it turns income tax planning’s central tenet:  defer the payment of tax as long as possible.  Preferably until the angel of death arrives with the gift of stepped-up basis, expecting only the small tip of possible estate tax liability.

Judicial tests for ownership in tax cases carefully plod through a bundle-of-sticks analysis.  Attributes like title and voting are balanced by an acknowledgment of the core importance of economic rights.  Nevertheless, financial derivative transactions that rearrange ownership attributes like Legos can allow a seller to retain enough attributes to persuade a court that a sale has not occurred, while substantially offloading the economic exposure of owning the underlying asset.

The 1995 short sale by Estee Lauder of her family company’s stock, believed not to produce taxable gain under traditional ownership analysis, preceded the 1997 enactment of the constructive sale statute at Internal Revenue Code Section 1259.  The statute provides a powerful tool to the government to label synthetic sales, or almost-sales, as realization events that require taxpayers to recognize all of the gain built into the underlying asset.  Brennan takes the statute at face value, disregarding tangential considerations such as the possibility that permitting non-realization for constructive sales beneficially reduces lock-in, and proposes a fix to its application.

Brennan takes as his example the variable prepaid forward contract (VPFC) transactions held not to create constructive sales in Revenue Ruling 2003-7 and in a recent Tax Court and Tenth Circuit case, Anschutz Co. v. CommissionerOthers have contended that Section 1259 has not lived up to its potential because of the ruling’s “giveaway” to the financial industry.  Brennan’s dissection reveals a key shortcoming: the failure to consider volatility.

In the ruling, Seller agrees to transfer to Purchaser formal ownership of a variable number of shares of publicly traded stock in three years’ time.  Purchaser transfers to Seller an upfront payment.  Seller agrees to transfer to Purchaser a payment in stock or cash in three years that accounts for some changes in the value of the stock.  Seller does not retain any risk of loss below $20, the stock price at the time Seller and Purchaser enter into the VPFC transaction.  Seller retains all of the potential for gain between $20 and $25 per share and 20% of the potential for gain above $25 per share.  Seller also retains the right to dividends.  The ruling does not mention the volatility of the value of the stock and/or the dividends.  It simply concludes that Seller’s delivery obligation at the expiration of the contract has “significant variation.”

The court case involved VPFCs entered into by a corporation controlled by billionaire Philip Anschutz and coupled with loans of about 95% of the underlying shares to the counterparty.  The counterparty paid the Anschutz firm about 80% of the shares’ initial value upfront, and the counterparty bore the economic downside and upside outside a band bounded at 100% and 150% of the initial value of the stock.  In addition, the counterparty received the benefit of all of the dividend payments on the stock if the final price was below 100% or above 150% of the initial stock value, plus the benefit of a portion of the dividend payments if the stock value fell within the band.

Reasoning that the loan transferred physical possession, the right to transfer and other ownership attributes, the Tenth Circuit affirmed Tax Court Judge Goeke’s decision that that a sale under common law principles had occurred with respect to the loaned shares.  More importantly for Brennan’s purpose, the Tax Court had also concluded that Section 1259 did not apply.  The Tax Court decision referenced Rev. Rul. 2003-7 and noted the absence of other guidance.  The constructive sale issue arose because Section 1259 would have taxed all of the stock’s built-in gain instead of the appreciation described by the difference between the upfront payment and the basis of the transferred stock.

The VPFC transactions in the ruling and the case transfer more economic downside and upside if the volatility of the underlying stock is higher.  On the facts of Rev. Rul. 2003-7, this is because there is a higher chance that a higher-volatility stock will land in the value ranges below $20 and above $25, where Seller has transferred all or most of the risk to Purchaser.  Dividend volatility is also important. Congress and the New York State Bar Association identified the issue of volatility around the time of Section 1259’s enactment.  Brennan operationalizes it.

The financial tool that Brennan uses is called delta value.  It is the first derivative of the value of the constructive sale transaction with respect to the value of the underlying asset.  To calculate it, Brennan disaggregates a constructive sale transaction into its component parts, calculates a delta value for each, and then adds the delta values together.  The formula for calculating delta value includes an input for volatility, which is higher if stock value or dividend payments are expected to have a wider variation.

If the value of the derivative transaction and the underlying asset move exactly in tandem, then the delta value equals one.  The more they diverge, the lower the delta value.  Assuming that a Seller in a VPFC transaction transfers upside and downside in a range outside a band right next to the original sale price, the delta value will be higher if volatility is higher.  Brennan shows that in the Revenue Ruling 2003-7 case, the delta value of the VPFC with respect to an underlying stock, disregarding dividends, ranges from 0.465 to 0.806 for volatility inputs of 10% to 100%, respectively.

In other words, assuming that the underlying stock is volatile, the VPFC described in the transaction gets very close to a sale.  And of course taxpayers would be more likely to agree to enter into a VPFC with respect to a volatile stock.

Dividend rights also affect delta value.  Especially if dividends are volatile, a Seller’s transfer of dividend rights to Purchaser, as in the Anschutz case, would increase the delta value.  In a “base case” using data based on the Anschutz transaction and assuming that dividends are proportionate to stock value, Brennan calculates that the dividend term contributes 0.113 of a total delta value of 0.913.

Brennan suggests legislative or regulatory action.  Representative Dave Camp’s House Ways and Means Committee has shown interest in the taxation of derivatives, but this seems like an administrative job.  The legislative history specifically “anticipated” Treasury regulations, and an expert administrative agency ought to be able to arrive at a good answer, especially if it figures out a way to make the financial industry work harder for its safe harbors.

Treasury could structure a process that (1) announces that Revenue Ruling 2003-7 requires clarification to account for volatility; (2) requests public proposals that use delta value or other methods to administer Section 1259 consistent with its stated purpose and legislative history; and (3) imposes length limitations and other “information filters” on submissions.  Of course, Treasury still needs the smarts and the guts to make the right decision in the face of industry pressure.  But the chances of success are better if the government frames the question.


Once a U.S. Corporation, Always a U.S. Corporation…

Omri Marian, Jurisdiction to Tax Corporations, 54 B.C. L. Rev. 1613 (2013).

Imagine a 19 year old college student in Texas stumbles upon a new business idea to sell built-to-order computers shipped directly to customers out of his dorm room.  The idea proves revolutionary, and the student is inundated with orders.  To grow the business the student forms a corporation, naturally in Texas.  Eventually the corporation grows into the largest personal computer maker in the world, with over 90% of its sales outside the United States.

Absent some significant tax planning, however, the company would pay US tax on all of its worldwide income, including the income from foreign sales.  This is because the United States taxes the worldwide income of all U.S. taxpayers regardless of the source of the income. On the other hand, an identical “foreign” company with identical sales would only be subject to U.S. tax on the income from sales made inside the United States..  The reason for this disparity is that, under U.S. law, a corporation is treated as a U.S. taxpayer if it is legally organized under the laws of the United States, any State thereof or the District of Columbia and foreign if it is not, regardless of business model or source of income.

The solution, therefore, seems obvious – simply move the corporation’s place of legal organization from the United States to some other country (preferably a country with a low or zero corporate income tax).  Unfortunately under so-called “anti-inversion” rules if a U.S. company changes its place of legal incorporation and, among other things, is not being bought by a foreign competitor or moving its primary place of business, it remains treated as a U.S. taxpayer, and pays U.S. tax, notwithstanding the move.

Taken together, this could be thought of as a “once a U.S. corporation, always a U.S. corporation” rule.  But this seems troubling.  After all, the company formed by the 19 year old kid in his dorm room is significantly different from the multinational behemoth of today.  Yet the strict, bright-line, all-or-nothing U.S. definition of corporate residence means the decision of the 19 year old kid to incorporate in Texas effectively locks all of the company’s profits into the U.S. tax net (or, at a minimum, requires significant U.S. tax planning) for perpetuity.  This arises not out of any affirmative policy choice of the United States but rather from the interaction of a set of ossified, confusing and convoluted corporate residency rules.

Omri Marian tackles this problem in his article Jurisdiction to Tax Corporations. In this article, Prof. Marian rejects the bright-line, all-or-nothing rules leading to the “once a U.S. corporation always a U.S. corporation” result.  Instead, he proposes replacing the regime with an instrumentalist one.  This involves a two-step approach: (1) determine the underlying normative goal of the corporate tax, and (2) implement whatever residency rule accomplishes that underlying goal.

For those unfamiliar with international tax scholarship, it may seem odd that such a proposal could come across as shocking to some.  Yet it could, precisely because, for the most part, the tax literature has tended to bounce between two definitions of corporate residence: (1) place of legal incorporation and (2) primary place of business and management.  Every time a problem arises with one test, someone proposes replacing it with the other, ad infinitum.  Prof. Marian rejects this paradigm.  To do so, he must make the controversial, yet ultimately correct, move of declaring that corporate “residency” in a globalized world is meaningless.  Rather, multinational corporations can establish residency under any of these rules without changing their ultimate business model at all.  So if corporate residency is utterly and completely meaningless from an economic standpoint, debating which method of corporate residency best reflects the true economics of the firm proves a losing battle.  Prof. Marian hammers home precisely this point.

There is much to like in this article.  A number of scholars have recently begun to argue that many, if not most, international tax rules have no independent underlying economic rationale and thus should be purely instrumental in their goals.  Prof. Marian demonstrates how this can apply to corporate residency.  In doing so, this article provides one of the first modern realistic avenues out of a perennial problem in the international tax literature.  Even if it is not the first do so, challenging long-held assumptions and recasting them in a way to move the debate forward provides a significant contribution to any field.  Prof. Marian accomplishes precisely this.

Having said that, I remain skeptical of the proposals made in the article.  At times this may be because I do not share the same underlying normative goals as Prof. Marian, at others because I do not believe the instruments he uses will actually achieve his goals.  For example, as one alternative Prof. Marian considers the normative goal of the corporate income tax to be a proxy tax on access to liquid capital.  Assuming this normative goal, the article proposes using the place of public listing as the jurisdiction of residence of the corporation.  True, this would permit countries that provide sophisticated capital markets to tax the income of such corporations.  But it would not act to tax the pool of underlying capital itself.  Unless there were strong rents available in a particular jurisdiction, there is no reason to believe that companies could not raise the exact same capital from somewhere else, such as the Luxembourg Stock Exchange, solely for tax purposes.

Even worse, there is no reason to think that Luxembourg would not offer low rates of tax for companies to list on the Luxembourg Stock Exchange as a form of tax competition.  Since Luxembourg (among other countries) already offers low tax rates to entice companies to relocate there, it does not seem absurd to think it could do so for a place of listing rule as well.  In fact, the world witnessed such a “race to the bottom” in the form of taxing interest on publicly-traded debt instruments in the 1980s, although at that time it was the United States leading the way by exempting foreign investors from U.S. tax on so-called “portfolio interest” specifically to attract foreign capital into the United States.

A purist approach, even if ultimately wrong, may well avoid such implementation questions, but an instrumentalist one could well fall prey to them.  Perhaps this is less an indictment of the article and more a complaint of international tax more broadly.

Ultimately, however, this is a theoretical article and on that front it succeeds.  I am in agreement with the conclusion, which states “Obviously, the model developed is not exhaustive, in the sense that it cannot possibly consider all possible purposes for which different countries choose to tax corporations. But its strength is in its flexibility to consider new purposes and interactions of various purposes in the specific contexts of each jurisdiction. As such, the model can provide guidance even with respect to purposes of corporate taxation not explicitly considered herein.”

This article establishes itself as part of a promising trend in international tax scholarship, one I hope more scholars pursue going forward.


Presumptive Collection: An Innovative Proposal for a Notoriously Difficult Problem

Kathleen DeLaney Thomas, Presumptive Collection: A Prospect Theory Approach to Increasing Small Business Tax Compliance, 67 Tax L. Rev. __ (forthcoming 2013), available at SSRN.

In Presumptive Collection: A Prospect Theory Approach to Increasing Small Business Tax Compliance, Kathleen DeLaney Thomas tackles the extensive, and notoriously difficult to address, problem of small business tax evasion.  She does so by proposing a novel solution to the problem: presumptive collection of tax liability.  Her solution is elegant, balanced, and a great example of how tax law professors can integrate scholarship from other disciplines with their detailed knowledge about tax law and compliance, in order to produce valuable real-world proposals.

Thomas starts off by detailing some of the well-known facts about the rampant tax evasion by small businesses.  These businesses, which have high opportunities to evade as a result of the lack of withholding and information reporting, engage in great amounts of evasion.  As a result, they are major contributors to the so called “tax gap,” and their evasion threatens the integrity of the tax system.

Thomas does not spend much time lamenting this problem before turning to her proposed solution.  Rather than focusing on the lack of information reporting and withholding, which are often discussed as the structural reasons that explain small business tax evasion, Thomas instead offers an insight that is not as frequently examined.  Small business owners, Thomas explains, generally do not receive a refund when they file their tax returns, whereas most wage earners (who are much more compliant) do receive a refund when they file their tax returns.  From a theoretical perspective, this matters because prospect theory suggests that when individuals face a gains frame (such as when they are receiving a tax refund) they tend to be risk-averse.  On the other hand, when individuals face a loss frame (such as when they stand to owe tax liability upon filing a return) they tend to be risk-seeking, which makes them more likely to evade.  Thomas offers a fair amount of evidence that this theoretical possibility in fact describes some of taxpayer behavior.  Based on this phenomenon, Thomas proposes that advance tax payments be collected from small business owners on a presumptive basis throughout the year.  As a result, when small business owners file their tax returns, more of them should find themselves in a gains frame and therefore, as a result of higher risk-aversity, they may evade less.

What is perhaps best about Thomas’s article is the nuanced nature of her proposal.  While actual presumptive taxation, popular at times in other countries and in tax theory, can reduce compliance problems, presumptive taxation can also create fairness problems.  The traditional income tax system seeks to tax based on some ability to pay, and presuming tax liability conflicts with that principle.   By proposing presumptive collection, but actual taxation based on the traditional income tax system, Thomas adeptly leverages the compliance benefits of a presumptive system, while attempting to preserve the fairness benefits of the traditional income tax system.  Thomas also carefully distinguishes presumptive collection from estimated payments.  Both result in tax payments being made prior to the actual filing of the year’s final income tax return.  However, since estimated payments require the taxpayer to make a determination regarding how much tax is owed, they put small business owners in a loss frame, potentially inducing undesirable risk-seeking behavior.  Presumptive collection avoids this problem by separating the collection from the taxpayer’s decision about how much tax is owed.

Of course, there are some potential problems with the proposal, which Thomas thoroughly and convincingly addresses in the Article.  Perhaps the biggest question is whether political realities would allow the proposal to be put in place.  That question should not stop scholars, such as Thomas, from thinking deeply about how to improve legal compliance, and advocating for worthwhile ideas.  Thomas’s innovative approach, her useful integration of prospect theory, and her attention to the details of the tax compliance framework make this idea worthwhile and the Article a pleasure to read.


The Limits of Even the Most Powerful Theories, or Why Tax Really Is Different

Alex Raskolnivok, Accepting the Limits of Tax Law and Economics, 99 Cornell L. Rev. 523 (2013).

What are the criteria according to which tax base design should proceed? In Accepting the Limits of Tax Law and Economics, Alex Raskolnikov cogently reminds us not to rely too heavily on the approaches associated with tax law and economics, even if we find the approaches of law and economics in other contexts appealing.

Until early in the last century, there was little room for theory, economic or otherwise, in tax base design. The blunt practicalities of tax collection left little room for taxes that were not focused on highly visible and measurable activities. The development of economic theory, and its application to legal rules in the framework of “law and economics,” has shifted the focus from what can be collected to what should be collected (and from what can fairly be collected given the constraints of politics) to what can efficiently be collected, meaning in general with as little adverse effects on market activities as possible. In Accepting the Limits of Tax Law and Economics, Alex Raskolnikov outlines the reasons tax designers cannot rely solely—and probably not even primarily—on the methods of law and economics.

In its early and most rudimentary forms, the methods of law and economics were congenial to scholars in law schools analyzing tax law and tax policy. Law and economics introduced in a systematic way the idea that legal rules should be developed with consideration not only of the fairness of their ex post application, but their ex ante effect on behavior, given that such rules should only be invoked to constrain rational actors as appropriate to maximize social welfare. It may once have been possible to develop tax laws under the pretense that tax law simply applied to human activity “as the tax law found it.” In reality, however, no one ever really expected that people would not arrange their activities so as to minimize their tax burdens, whether by not finishing the thresholds for their front doors (under a property tax that treated unfinished buildings differently from finished ones), by separately purchasing springs as an add-on to springless carriages (under a carriage tax that increased according to the extravagance of the vehicle) or by investing in municipal bonds (under a federal income tax that was thought incapable of reaching the interest earned on such bonds.) Therefore the mode of analysis that is the hallmark of “law and economics” was early and easily applied to questions of tax policy. The mantra that the goal in tax design was the minimization of distortion in the operation of markets in which only rational actors participate was readily accepted in tax policy analysis, especially during the period when income was regarded as the most politically palatable tax base.

Indeed, in comparison with other administrable tax bases, the income tax was more likely than other taxes to pass muster under the efficiency criteria advocated by the principles of law and economics. If some sources of income were predictably taxed more lightly than others, taxpayers could be expected to pursue those sources of income. Even if all of the private benefit associated with these alterations in taxpayers’ activities were eliminated by changes in the relative costs of engaging in those activities, resources would be misallocated. Articulating tax policy was simply a matter of identifying those places in which tax rules interfered with market outcomes (and reducing that interference) and identifying market failures that could be remedied by alterations in tax rules. The guiding principle for tax policy (or at least income tax policy) for much of the mid-twentieth century was, therefore, the quest for a “comprehensive” tax base.

The problem with these early applications of law and economics to tax design was, of course, the distortions that even the most comprehensive income tax encourages on the labor/leisure and the consumption/savings margins. These distortions soon became the focus of attention, since they can under some assumptions be greater than the distortions that a well-designed income tax avoids (compared to, for instance, a real property tax).

These efforts by those immersed in economic theory to address these shortcomings of the income tax has led to various articulations of “optimal tax theory.” This label is sometimes limited to the particular line of reasoning that concludes that a uniform lump-sum tax is the least distortionary and thus the best of all possible taxes, but is often extended to any theory that insists that minimization of distortion must be the principal goal in tax-base design. Raskolnikov’s discussion is aimed at showing us just how far from anything useful this theoretical approach has proved.

Raskolnikov’s essay articulates the ways in which the task faced by tax theorists invoking “law and economics” is very different from the task faced by theorists of other regulatory regimes relying on such principles. Indeed, one of the clearest take-aways is that tax is not just another regulatory regime. (Raskolnikov’s focus is strictly on “taxes” that are necessary to provide government with revenue, and his analysis does not apply to any use of tax instruments to deliberately affect market behavior (P. 536-37), for which more typical law-and-economics methodologies may be useful.) Therefore its practitioners cannot, as other law-and-economics practitioners can, simply either assume an ideal regulatory regime and propose changes in existing rules to produce such a regime or assume that existing rules approach an ideal solution and identify the ways in which such rules could be altered to produce results even closer to the ideal solution.

Raskolnikov explores three reasons why tax design is different from, and more complex than, simple regulatory design. First, there is “the undeterrability problem.” The simple regulator seeks to set the right balance between an activity that produces both social benefits and social costs such that those activities with excess social cost are deterred. But the primary means of avoiding taxes is likely to be avoiding participating in economic activity (that is, by not working and by not saving). The private benefit to be gained from such a tax avoidance response simply is not a social benefit (in Raskolnikov’s terms, tax avoidance responses are “irredeemably inefficient”)—a condition not present in the problems addressed by simple regulators. It is virtually impossible in any real world to develop sanctions that can effectively deter such tax-avoiding behavior. As long as taxes must be imposed in the absence of information about what actions would have been taken in the absence of taxes, irredeemable tax avoidance behaviors cannot be deterred.

Second, the simple regulator can assume that redistribution is somebody else’s problem (and is encouraged to do so under most standard law and economics analyses). The tax designer cannot, since redistribution is what taxes (as he uses the term) are supposed to be. Third, the simple regulator (or at least the evaluator of the simple regulation) can assume a relatively uncontroversial baseline, and propose changes that move closer to that baseline. The tax designer has no such pre-established baselines on which she can legitimately rely. There is simply too much distance between the tax base we have (and any that we can imagine devising administrable rules for) and the tax base suggested by optimal tax theory (that is, a tax system limited to a nonlinear wage tax) to allow the ordinary methods of law and economics to operate. And, to complicate things further, even the optimal tax base incorporates distortions that would be unacceptable under standard economic theory.

The bottom line for Raskolnikov, especially with respect to the second and third reasons tax design is different, is the familiar conclusion that law-and-economics practitioners who focus on tax base design have little to contribute to a debate that is not essentially economic but is instead political and moral. The difficult choices in tax base design are all those that are assumed away in the typical law and economics approach. The less common feature of Raskolnikov’s discussion is his willingness to accept the typical law and economics framework on its own terms, and his applause for the techniques of law and economics in tax policy analysis when appropriately limited. At times, his approach requires a lot from the reader, since not all of the framework is presented in ways that those not already schooled in it can digest. But regardless of one’s prior knowledge and prior assumptions about law and economics, one cannot help but agree with Raskolnikov’s ultimate conclusion that its framework is inevitably inadequate to the task of the larger problems in tax base design.


Recognizing and Rethinking Federal-State Tax-Base Conformity

Ruth Mason, Delegating Up: State Conformity with the Federal Tax Base, 62 Duke L.J. 1267 (2013).

In contemporary governance, while the U.S. Constitution recognizes the fifty states as sovereign entities, federal and state governmental policies and operations are functionally quite intertwined.  Nevertheless, state governments frequently like to show flashes of independence, particularly on hot button political issues.  Hence, we have seen states like California and Massachusetts getting ahead of their federal counterparts in adopting laws and policies to protect the environment and embrace gay marriage.  On the opposite side of the political spectrum, we have states like North Dakota, Texas, and Arizona challenging federal laws and policies regarding abortion rights, health care, and immigration.

Tax policy ranks among the more heated issues in modern politics.  Politicians argue a lot about what rates to apply to which taxpayers, but the tax policy debate is not limited to tax rates.  It is strange, therefore, just how little state individual income tax regimes differ from their federal counterpart.  State tax laws tweak the federal model here and there around the edges, but in the main, all of the states that impose a broad-based income tax rely either explicitly or implicitly on federal tax laws to define their tax base.  In her thoughtful article, Delegating Up: State Conformity with the Federal Tax Base, Ruth Mason thoroughly documents and persuasively challenges federal and state lawmakers to think more carefully about the consequences of this phenomenon.

Mason begins by documenting the extent to which state income tax regimes conform to the federal model.  Forty-one states impose a broad-based income tax, and none of them determine income tax due as a simple percentage of federal tax liability.  Six do use federal taxable income as a starting point; twenty-nine start with federal adjusted gross income; and the remaining six do not facially conform but nevertheless rely substantially on federal concepts, definitions, and forms like W-2s, 1099s, and federal tax return schedules.  All of these states have adopted minor adjustments from federal tax laws, like requiring taxpayers to recognize interest earned on other states’ bonds or excluding federally taxed Social Security benefits.  But in the main, for all forty-one states with a broad-based income tax, the state tax base closely tracks the federal tax base.

As Mason recognizes, this federal-state tax-base conformity has several advantages.  For example, conformity reduces the costs of both taxpayer compliance and state government tax administration; it also minimizes the potential for both double taxation and state tax arbitrage.  But, she argues, in defining income, Congress has made numerous policy choices that favor or disfavor different classes of taxpayer and incentivize or disincentivize various behavioral choices.  Further, the federal income tax system has expanded far beyond mere revenue raising to incorporate a variety of social welfare and economic incentive programs.  Conforming state income tax laws to the federal model means signing on to all of those congressional policy choices as well—thereby reducing state autonomy and policy experimentation.  Indirectly adopting congressional policy choices in this way is nontransparent and reduces political accountability.  Finally, federal tax law changes can yield substantial revenue volatility in states that fail to make corresponding adjustments to their own laws in real time, and Congress’s habit of changing the federal tax laws often and late only exacerbates the difficulty.

Mason also offers an interesting discussion of the relationship between federal-state tax-base conformity and state tax competition.  An extensive literature debates the extent to which state tax competition is good, by constraining self-interested politicians who might otherwise be tempted to maximize revenue to pursue inefficient pet projects, or bad, by inspiring a race to the bottom that undermines the provision of important public goods.  Without taking a position on that debate, she posits that federal-state tax-base conformity at least facilitates state tax competition and political accountability therefor—for example, by requiring special reporting for deviations, thus contributing to tax salience.

Mason concludes that the prevalence of federal-state tax-base conformity suggests that its advantages outweigh its disadvantages.  For that matter, as Mason explains, fully decoupling federal and state individual income tax laws would itself be financially and politically costly and, for that matter, may be nearly impossible in some instances.  Partial decoupling through piecemeal deviations—additions to and subtractions from the federal base, or more and different state tax credits—offers many advantages:  reflecting the policy preferences of state voters, improving political accountability, tailoring the tax base to local needs, and minimizing revenue volatility.  But even partial decoupling carries significant costs for both state taxpayers (e.g., increased compliance costs) and state legislators (e.g., heightened political risk associated with greater awareness of individual deviations).

Instead, Mason proposes several incremental strategies at both the federal and state levels to ameliorate the disadvantages of federal-state tax conformity.  For example, she proposes that states increase public awareness by publishing annual tax expenditure budgets, reduce revenue volatility through static rather than dynamic incorporation of federal tax laws, or at least starting their tax liability calculations with federal adjusted gross income rather than federal taxable income.  She encourages Congress to pay more attention to the effect of federal tax law changes on states and to simply produce a list of changes each year to facilitate the ability of state lawmakers to adopt corresponding changes as needed.  Mason also calls for more consideration of the effects of federal-state tax-base conformity in ongoing debates over federal tax policy and for more research into the nature and scope of those effects.  Whether or not lawmakers and scholars heed her call, she has firmly established the case that they should.