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.

 
 

What Legal Scholars Need to Know About Economic Research on Taxation: The Evidence Thoroughly Debunks the Conventional Wisdom

Peter Diamond & Emmanuel Saez, The Case for a Progressive Tax: From Basic Research to Policy Recommendations, 25 Journal of Economic Perspectives 165 (Fall 2011).

Too often, policy research relies more on the misleadingly elegant results of economic theory than on actual evidence. Tax policy discussions, as I will describe below, are especially prone to being infected by this evidence-free approach to analysis. Fortunately, two of the best public finance economists in the world, Peter Diamond and Emmanuel Saez, have recently provided a much-needed antidote: The Case for a Progressive Tax: From Basic Research to Policy Recommendations. To understand just how important their article is, it is necessary to appreciate the deep roots of the problem that their article addresses.

As an economics graduate student, and later as a young economics professor, I often felt a deep sense of unease about the disconnect between economic theory and the empirical research that was relevant to evaluating that theory. Overwhelmingly, we learned in classes (and from theoretical scholarship) a series of “known results” that followed from the manipulation of economic models—results that, however nicely derived from the assumptions of those models, either were not backed up by any empirical research, or the magnitude of which turned out to be quite trivial.

For example, in macroeconomic theory courses (both those that were required of all first-year graduate students, and those that were only required of those of us who planned to specialize in macroeconomics), we learned that nearly all macroeconomic models included a deceptively simple assumption: Increases in the real interest rate (r) cause decreases in real business investment (I), and decreases in r lead to increases in I. If I is desirable, therefore, r should not rise.

This was, moreover, presented to us as not merely an assumption that “makes the math work,” but as an intuitively obvious matter as well. The real interest rate is a “price,” that is, it is the cost of borrowing money to finance business investment, and every good economist simply knows that an increase in the price of anything leads to a decrease in its demand. In a revealing attempt to invoke the imprimatur of the hard sciences, this was confidently referred to as an application of “the law of demand.”

But how big is the response of I to r? Can it be entirely unresponsive? Can it, like some well-known “paradoxes,” respond positively to changes in r, rather than negatively? When I began to look at the empirical research, I found not just that the evidence of a negative relationship between I and r was weak, but that decades of research had failed to turn up credible evidence of any relationship at all between the two variables (even ignoring questions regarding the direction of causality). Almost as a hobby, I found myself collecting quotations from top-tier macroeconomists, all of them confessing in various ways, “We keep looking for that elusive negative relationship between r and I, but we can’t find it.”  Even so, if you ask almost any economist today, “What is the relationship between r and I?” he will almost surely say, with great confidence, “They’re inversely related.”

After I became a legal scholar, I focused on tax law and policy. This, too, is an area in which the “law of demand” is supposed to give us definitive answers to important questions. Taxes alter the prices that people face, and therefore, economic theory should supposedly be essential in telling us how to think about tax issues.

What makes the landscape of legal scholarship different, of course, is that most legal scholars have not been trained in economic theory. Perhaps understandably, therefore, they tend to defer to the views of economists on many issues. If an economist confidently states that “Economic theory tells us _____,” the temptation for many legal scholars is to say, “Well, I don’t know the economics, so I am in no position to say otherwise.”

This deference to economists, of course, is hardly limited to legal scholars. Journalists, including business journalists, tend to regurgitate a standard set of statements about the world that are, in fact, nothing more than unexamined conclusory statements that the journalists have heard from orthodox economists. As one of many examples, the top economics writer for The New York Times confidently claimed a few years ago that “higher tax rates discourage work and investment, two crucial ingredients for economic growth. But higher taxes on consumption don’t have nearly the same effect as taxes on incomes or companies. If anything, consumption taxes encourage savings, which lifts investment.” How did he know any of this? The author did not even feel the need to justify his assertions. Apparently, he felt that he was saying nothing more controversial than claiming that the sun rises in the East.

Such assertions of cause and effect are part of what many public finance economists are happy to tell us are “known results” from economic theory. After hearing these claims by economists, legal scholars who study taxation have, at least by my observation, generally (and quite erroneously) concluded that those results must be backed up by evidence and are uncontroversial among people who “know the economics.” Those claims are, many people seem to believe, simply the Economic Truth. Other statements of supposed truth include the “double distortion” argument and the claim that inefficiency rises as the square of the tax rate, which are used to support the ideas, respectively, that we should not tax capital income, and that increases in marginal tax rates are increasingly harmful to the economy.

Similarly, it is often taken as received truth that subsidizing poorer people’s wages creates a disastrous work disincentive. If a person believes that statement to be true, he can then insist that he does not want to ignore the plight of the poor, but that “economic theory tells us” that indulging our soft hearts by helping the poor would be pure folly.

The problem is that none of those cause-and-effect relationships is established by economic evidence—and, for most of them, the evidence leads to precisely the opposite conclusions. Just as I had found that the supposed relationship between interest rates and investment was not what was so often assumed, the empirical research on all of these tax-related questions does not support the received wisdom, either. By my reading, in fact, the evidence for those assertions is so weak that continuing to believe in them is little more than an act of faith—or superstition.

What I had not done, and what I had not seen from any other scholar, was to summarize the state of knowledge—both theoretical and empirical—about taxes and their effects on important social outcomes, to show that there is no “there there” to back up these oft-heard claims. Luckily, Diamond and Saez decided to do that difficult and important work. In the Fall 2011 issue of the Journal of Economic Perspectives, they summarized the best available research and, based on that evidence, made three specific recommendations:

(1) “Very high earnings should be subject to rising marginal rates and higher rates than current U.S. policy for top earners,”

(2) “Tax (and transfer) policy toward low earners should include subsidization of earnings and should phase out the subsidization at a relatively high rate,” and

(3) “Capital income should be taxed.”

These recommendations are not the personal opinions of the authors. They are the conclusions that can be drawn from the existing body of economic research. In short, three of the key assumptions that too many public finance economists have successfully exported into legal tax policy research, and that legal scholars had no particular reason (or standing) to question, are unsupported by the evidence.

What makes the Diamond and Saez paper especially helpful is that it was published in an economics journal that requires authors to minimize the use of mathematical exposition, which makes the results comprehensible to non-economists. (For those who care about credentials, it also helps that Diamond recently won the the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, commonly—though inaccurately—known as the Nobel Prize in Economics.) The exposition, while still tough sledding in places, allows interested readers to follow the logic and evidence that the authors present.

Notably, Diamond and Saez do not merely say that the evidence is lacking to support the conventional superstitions about taxes, but that the evidence supports the opposite conclusions: that marginal tax rates on high incomes should be increased, that lower incomes should be subsidized, and that capital income should be taxed.

Diamond and Saez are not writing on a blank slate. They are debunking received wisdom, exposing shibboleths that legal scholars need to un-learn if scholarship in taxation is to move forward, fulfilling its promise to guide policymakers toward wise decisions. For legal scholars with interests in tax policy, this is the essential article to read.

 
 

Trade, Currency, and International Cooperation

It’s always nice when you can combine outside reading for fun with something that is educational and at least indirectly professionally relevant.  Benn Steil’s economic and diplomatic history of the 1944 Bretton Woods conference, which established the post-World War II global framework for currency relationships and international trade (while also creating the International Monetary Fund and the World Bank) filled this niche for me during a quiet weekend.  While the subject is not literally or directly related to taxation, it touches so closely on finance, macroeconomic policy, and international trade as to occupy a common universe with overlapping concerns.

The book tells a lively story, in which U.S. Treasury economist Harry Dexter White – an ardent economic nationalist yet also a Soviet mole – thoroughly squelched the great English economist John Maynard Keynes (the U.K.’s chief negotiator) in establishing the postwar regime for trade, currency, and capital flows.  With the U.S. economically dominant and the U.K. reduced to begging for loans, Keynes would have had no chance even had he been better at converting his analytical and epigrammatic skills into diplomatic ones.

The resulting Bretton Woods framework (which lasted until 1971, when President Nixon abruptly canceled the dollar’s fixed-rate convertibility to gold) responded to the view that, in the 1930s, trade wars and competing currency devaluations had both prolonged the Great Depression and helped set the stage for World War II.  But it also helped to ensure the dollar’s hegemony and to advance the U.S.’s interests as a dominant creditor nation that favored open markets, global currency stability, and an end to the U.K.’s hopes of restoring its own prewar position.

In terms of broader takeaways, Steil shows how difficult, unresolved, and relevant to our own very different era the underlying issues were.  Three basic global currency models were competing for primacy:

• Gold standard: This had worked pretty well in the nineteenth century, but was fingered by Keynes as a prime cause of the horrific 1930s global macroeconomic experience, and has few adherents today.  The core idea behind it is that, stupid and arbitrary though it may be to shackle national macroeconomic policy to one’s holdings of an inert metal, shackling can at least reduce discretion that one fears would be misused.

A key question, of course, is how discretion would be misused.  Those who fear that governments will under-respond, not over-respond, to persistent unemployment – a problem both in the 1930s and today – may view the shackling as only making things worse.  And if governments that cannot dispense with gold convertibility don’t sufficiently anticipate the problems that falling gold supplies would cause them, then the gold standard, rather than offering a useful constraint, may simply ensure bumpier landings.

• Active management by experts of trade balances, capital flows, and relative currency values: Keynes believed that pure free trade and allowing unrestricted cross-border capital flows had been as completely discredited as the gold standard by the experience of the 1930s.  And as for allowing national currencies simply to float against each other on global markets, this did not need to be discredited, as it had not yet become widely credited.  Today, most mainstream views are more pro-market than Keynes was, and place less faith in rule by experts.  However, his concern that countries’ national policy aims might be undermined by unfettered trade and capital flows, and by changing relative market values for competing currencies, remains pertinent.  The policy aims that potentially may be undermined range from tax enforcement, to maintaining full employment and high wage levels, to addressing internal distributional concerns, to limiting one’s exposure to the inbound transmission of financial panics.

• The dollar-based Bretton Woods model: The deal that came out of Bretton Woods, pushed through by the U.S. via brute force rather than intellectual consensus, effectively made the dollar and gold co-equal global “gold standards” (so to speak) for monetary wealth-holding and cross-border trade.  The U.S. proved unable, however, to keep one foot on each of the two barrels that Bretton Woods required it to straddle: basing dollar issuance both on the level of Fort Knox reserves that we were ready and willing to exchange for dollars, and on our own national policy needs or preferences.

Yet the dollar’s global preeminence as a reserve currency has survived the end of gold convertibility – contrary to what anyone in 1944 would have expected, especially if they had foreseen the Nixonian quasi-default.  We continue to benefit from the dollar’s global position, unless one regards seigniorage and our continued ability to borrow at low interest rates in our own currency as merely giving us more rope with which to hang ourselves in the end.

While people increasingly question the dollar’s ongoing viability as the global reserve currency, no rivals are discernibly on the horizon.  The Euro’s decline arguably suggests that Keynes was too sanguine in believing that multinational institutions could manage a global currency when national governments retained separate policy discretion.  If the Euro can’t work, what chance would a truly global currency – advocated by Keynes pre-Bretton Woods, and more recently by Chinese leaders – realistically have?  And the Chinese renminbi seems unlikely to attract or deserve widespread dollar-like trust anytime soon.

As Steil discusses at the end of this good read that is also good for you, if the dollar loses its current global status and no substitute reserve currency emerges, not just the U.S. will suffer.  He notes that China, our leading creditor, holds U.S. government securities worth more than $1,000 per resident.  Thus, China’s clear motivation to challenge a global status quo that favors our interests is offset by a “mutual assured destruction” problem.  They cannot sink the dollar without giving themselves a gigantic punch in the nose.  Steil closes by noting, that, while the U.S. and China therefore have every reason to work constructively together through the next few decades’ political and economic challenges, the same was true of Germany and England just over 100 years ago, as they sought to recalibrate their relationship in light of Germany’s global ascent.  We know what happened that time around.

 
 

Taxation and the Family: The Next Generation

• Anne Alstott, Updating the Welfare State: Marriage, the Income Tax, and Social Security in the Age of the New Individualism, Tax L. Rev. (forthcoming, 2013) available at SSRN.
• Shari Motro, Preglimony, 63 Stan. L. Rev. 647 (2011).

The tax treatment of marriage, children, and the family unit has attracted increasing attention in the past few years. The most dramatic example is the same sex or “gay marriage” phenomenon, where academics—Patricia Cain and Anthony Infanti come particularly to mind—have frequently anticipated real-world developments. But taxation of heterosexual couples is stuck in a similar time warp, and scholars have been no less aggressive in trying to catch up.

Two authors in particular have done provocative work in this area.  The first, Anne Alstott, has a long track record: her book “No Exit” describes the unique phenomenon that is motherhood and the need for tax, spending, and social policies to recognize that uniqueness.  In a more recent article, “Updating the Welfare State: Marriage, The Income Tax, and Social Security in the Age of the New Individualism,” Alstott focuses specifically on the tax component.  She argues that, because of the overall decline in marriage and the concentration of marriage among higher-income groups, it is no longer appropriate to organize the taxation of families around the existence of the marriage relationship. The most obvious implication is that joint returns should be repealed and replaced with separate, individual returns or (more ambitiously) with combined returns for households whether or not organized by marriage. The social security system would likewise be amended to replace spousal benefits with a system that emphasized caregiver relationships.  Many additional portions of tax and nontax law would require similar adjustment: Alstott does not purport to provide a complete list but rather to focus attention on the paradigm shift from which these changes would flow.

If Alstott is concerned primarily with people who have children, Shari Motro is more immediately concerned with the process of making them.  In an earlier article, “The Price of Pleasure,” Motro argued that men who impregnate unmarried lovers should have a legal responsibility toward the women they make pregnant as well as any potential offspring.  In her article “Preglimony,” which appeared in the Stanford Law Review, Motro takes the somewhat softer position that—if men are not legally required to provide such support—the tax law should provide a deduction to those who agree voluntarily to do so. Combining tax and feminist analysis, she argues that such a system would both encourage responsible behavior and support a relational ethos in place of the individualist one that now governs (or is assumed to govern) nonmarital sexual activity.  While recognizing that this function has traditionally been performed by marriage, Motro argues—convincingly, in my view—that many or even most lovers are likely to remain unmarried and the law should properly recognize this phenomenon.

There is no shortage of debatable points in Alstott’s or Motro’s papers.  Conservatives may ask, if marriage is associated with so many benefits, do we really wish to punish rather than reward it?  Skeptics may likewise ask if a small tax credit will be strong enough medicine to combat a more generalized form of social breakdown.  Still, by addressing the issue of social change in intellectually honest terms—by breaking out of the sterile dichotomy of “married” and “single” to look at what is actually going on between men and women in the real world—both scholars have made an enormous and lasting contribution.  It remains to be seen if the real world will keep up with them.