Discrimination Against Interstate Commerce vs. Double Taxation

For good reasons on balance, the best academic work in tax (and other) law has moved far away in recent decades from focusing primarily on which answers to particular questions are legally correct. Not only have scholars wanted to pursue larger game than just the current, inevitably flawed, state of the law, but it is often hard to say what “legal correctness” means. Writing about policy, rather than just about legal correctness, not only broadens the menu of possible topics, but permits one to devise clearer criteria for assessing the merits of competing arguments.

There is, however, a downside to thus broadening, diversifying, and deepening the menu of favored topics. Having a positive influence on real world legal outcomes, especially if one can get there without having to tailor one’s analysis or conclusions in the manner of either a politician or a hired litigator, is both good in itself and something that we ought to care about—both as lawyers and as academics—as a matter of professional responsibility.

It is therefore a great thing to see tax academics and other members of the broader tax policy community actually swaying the outcome of a Supreme Court case in a good way. This happened in Comptroller v. Wynne, decided on May 18, 2015, in which an unusual Supreme Court majority composed of three conservatives (Alito, Kennedy, and Roberts) and two liberals (Breyer and Sotomayor) converged to strike down a Maryland income tax rule as discriminatory against interstate commerce. The majority opinion not only extensively cited work by tax scholars, but really relied on it, not just to decide the case at hand, but also to clarify the often-vexed law of how one should define discrimination under the dormant commerce clause. The Court drew on two amicus briefs (one by Michael Knoll and Ruth Mason and the other lead-authored by Alan Viard) which arose out of and/or applied academic work by both sets of authors,1  and gave both coherent economic content and usable formulations to the potentially nebulous idea of tax discrimination.

Why might it be desirable for the courts to strike down clear instances of interstate tax discrimination? It’s well-known that, as soon as two jurisdictions’ income tax systems differ even just in rates, perfect tax neutrality is unattainable as between economic activity in any one jurisdiction and both that which is inbound and that which is outbound from its perspective. So the courts cannot mandate full neutrality, short of requiring complete uniformity between tax systems. Nor can they police all interactions between jurisdictions’ tax rules that might happen to disfavor interstate commerce in particular instances, simply due to incomplete harmonization between the jurisdictions’ rules.

However, there is reason to think that jurisdictions will sometimes be inclined to impose undue burdens on cross-border activity, whether because outsiders can’t vote or due to the set of internal collective action problems that may yield protectionist legislation even when this harms local consumers. Thus, assuming a good enough test for discrimination against interstate commerce, the courts can potentially improve public policy by applying it. Unfortunately, reflecting the difficulty of the underlying conceptual issues, courts have often done quite poorly at devising workable tests.

In this regard, as Mason and Knoll have written, one good tool that actually can be found in existing Supreme Court jurisprudence is the “internal consistency” test. Here one asks, about a tax rule such as that which Maryland applied in the Wynne case: If all jurisdictions applied the same rule as this one, would cross-border activity be disfavored? In illustration, suppose New York taxes all outbound investment but no inbound investment, while New Jersey taxes all inbound investment but no outbound investment. While this would be unfortunate for New York-to-New Jersey investment, it wouldn’t violate internal consistency. Use of the test may be motivated by the points that (a) there might be good reason for a state’s focusing either just on inbound or just on outbound investment, and (b) neither New York nor New Jersey is inherently to blame if the other state happened to make an opposite choice.

As generalized by Viard, one can put the point roughly as follows. Just by looking at one jurisdiction’s set of rules, one can discern discrimination against interstate commerce if the sum of (a) the tax rate on outsiders’ in-state income and (b) the tax rate on residents’ out-of-state income exceeds (c) the tax rate on insiders’ in-state income.2  Thus, for example, if Maryland were to tax purely in-state income at 5 percent, and all inbound and outbound income at 3 percent, it would be discriminating against interstate commerce, as two identical Marylands would levy a 6 percent combined rate on cross-border activity.

In actual practice, what Maryland did was combine fully taxing inbound income by nonresidents, with partly taxing outbound income by residents. For the latter, Maryland allowed a credit for taxes levied by other states, but only for a portion of the Maryland income tax liability. While the Maryland Court of Appeals had struck down this approach as discriminatory against interstate commerce, its ground for doing so was incoherent, reflecting an aversion to “double taxation” that the Supreme Court was unlikely to affirm. Conceptually, what matters is the overall tax burden on economic activity, not how many times one is taxed. And given the conundrum illustrated by the New York / New Jersey example above (which state should be treated as the one that’s “wrong”?), it is hard to base a workable tax discrimination test on the supposed principle of preventing double taxation.

The Supreme Court’s test is better. It required Maryland to devise a nondiscriminatory approach of some kind, based on the internal consistency / total tax burden analysis advanced by Knoll and Mason and by Viard and co-authors, and not necessarily including the use of tax credits. Considered in isolation, the result in Maryland Comptroller v. Wynne is surely of only modest importance. But the authors of the above amicus briefs, by effectively deploying their professional expertise regarding coherent legal and economic analysis in the service of improving the law, have not only put dormant commerce clause analysis generally on a better path, but offered an inspiring example to the rest of us.

  1. See Ruth Mason, Made in America for European Tax: The Internal Consistency Test, 49 B.C. L. Rev. 1277 (2008); Alan D. Viard, The Real Issue in Wynne is Discrimination, Not Double Taxation, State Tax Notes, January 15, 2015. []
  2. Viard, supra, at 46. As Viard explains, the computation must be slightly adjusted to reflect tax rate interactions. []
Cite as: Daniel Shaviro, Discrimination Against Interstate Commerce vs. Double Taxation, JOTWELL (May 27, 2015) (reviewing Michael Knoll and Ruth Mason, What Is Tax Discrimination?, 121 Yale L.J. 1014 (2012) and Ryan Lirette and Alan D. Viard, State Taxation of Interstate Commerce and Income Flows: The Economics of Neutrality (American Enterprise Institute Economic Policy Working Paper 2014-07, 2014)), http://tax.jotwell.com/discrimination-against-interstate-commerce-vs-double-taxation.

Do Corporate Managers Have a Duty to Avoid Taxes?

Reuven S. Avi-Yonah, Just Say No: Corporate Taxation and Corporate Social Responsibility __ NYU J. Law & Bus. __ (forthcoming), available at SSRN.

The recent wave of corporate inversion transactions, in which domestic companies essentially move their headquarters abroad to lower their U.S. tax bill, is just the latest in a decades-long trend of aggressive tax avoidance behavior by corporations. From the government’s perspective, inversions and other tax avoidance strategies erode the U.S. tax base and impose a costly enforcement challenge on Treasury and the IRS. But from the perspective of corporate managers, aggressive tax planning may simply be part of the corporation’s duty to maximize shareholder value. Reuven Avi-Yonah questions this latter proposition in Just Say No: Corporate Taxation and Corporation Social Responsibility. He offers a compelling argument that corporate managerial duties are not hopelessly at odds with the goal of promoting better corporate tax compliance.

Avi-Yonah frames the issue of corporate tax avoidance as one of corporate social responsibility (CSR). If it is legitimate for corporations to engage in activities that do not directly benefit shareholders—for example, involvement in philanthropic causes—then it should be legitimate for corporations to act as good tax citizens. On the other hand, if CSR is outside of the scope of legitimate corporate functions, then presumably corporations should seek to minimize their tax liability as much as possible.

Avi-Yonah argues that the legitimacy of CSR depends on our legal theory of the corporation. Under a “real entity” view of the corporation, under which a corporation has rights and duties similar to those of an individual, CSR is not required but is praiseworthy and should be encouraged. Under an “artificial entity” theory, which views the corporation as a creature of the state, CSR may fulfill the corporation’s obligations to the state and is required in at least some cases. However, the dominant view of the corporation in the United States is the “aggregate” theory, under which the corporation functions as an aggregate of its shareholders. To the extent that CSR involves activities that do not maximize shareholders profits in the long run, it is illegitimate under an aggregate theory.

The question, then, becomes how to square the theory that corporations exist to maximize shareholder profits with the goals of the U.S. tax system. One fascinating aspect of the article is the historical perspective that Avi-Yonah offers with respect to this question. Although, he notes, “the goal of shareholder profit maximization can naturally lead to corporations trying to minimize taxes and thus enhance earnings per share,” Avi-Yonah argues that this was not always a guiding principle among corporate managers. Rather, he asserts, this view has evolved over the past few decades due to several factors. First, the increasing use of equity-based compensation for managers (stock options, for example) has created more focus on earnings per share than in the past. Second, big accounting firms changed the landscape of corporate taxes in the early 1990s when they began marketing and selling tax shelters to corporate clients. Third, lower effective tax rates and increased earnings per share among some corporations has pressured others to adopt aggressive tax strategies in an effort to stay competitive.

Despite the proliferation of the modern view that aggressive tax avoidance is an inherent part of shareholder profit maximization, Avi-Yonah offers several reasons to be skeptical. First, from a theoretical standpoint, he argues that corporations have an affirmative duty to pay taxes, even under an aggregate view of the corporation. If CSR is not a legitimate corporate function, then social problems must instead be addressed by the government. However, if corporations are relieved of the obligation to pay taxes, then the government cannot collect adequate revenue. And without revenue, the government cannot resolve the social issues for which it is responsible. The result, Avi-Yonah argues, would be a theory under which neither the government nor corporations can adequately deal with social problems, which is an unacceptable outcome. Thus, aggregate theory must require corporations to pay taxes to enable the government to carry out the social functions that corporations themselves cannot legitimately perform.

Avi-Yonah moves beyond the theoretical and also offers some practical reasons to question the premise that shareholder profit maximization requires aggressive tax avoidance. For example, he points out that, historically, corporations were able to compete and maintain attractive share prices without resorting to abusive tax strategies. Further, he argues, there is not clear empirical evidence establishing a link between lower effective tax rates and higher share prices.

Accepting that corporations are not obligated to engage in aggressive tax behavior still leaves open the question of how to distinguish between legitimate tax planning and the abusive avoidance strategies that policymakers want to discourage. But while it may be difficult for the IRS and courts to make this distinction, corporate managers are usually well aware of whether a particular transaction is motivated by genuine business considerations or by tax avoidance. Thus, Avi-Yonah argues, “a corporation can be legitimately expected to police its own behavior in this regard, without worrying too much about where the line should be drawn.”

Avi-Yonah’s article doesn’t attempt to address how we might encourage corporate managers to police themselves with respect to aggressive tax planning. But he offers an important and unique perspective on how policymakers might address corporate tax avoidance more generally. Perhaps, as Avi-Yonah suggests, the lines between acceptable and unacceptable tax planning should be drawn by those armed with the relevant information—the corporate managers themselves. What’s still unclear, however, is how to make the leap from saying that paying more corporate tax is legally acceptable to convincing managers that paying more corporate tax is desirable. Avi-Yonah’s article raises the possibility that difficult questions such as this one may be better addressed by corporate law rather than by the tax law.

Cite as: Kathleen DeLaney Thomas, Do Corporate Managers Have a Duty to Avoid Taxes?, JOTWELL (April 29, 2015) (reviewing Reuven S. Avi-Yonah, Just Say No: Corporate Taxation and Corporate Social Responsibility __ NYU J. Law & Bus. __ (forthcoming), available at SSRN), http://tax.jotwell.com/do-corporate-managers-have-a-duty-to-avoid-taxes/.

Non-U.S. Acquirers: Clients for U.S. Targets’ “Locked-Out” Earnings?

Andrew Bird, Alexander Edwards, & Terry J. Shevlin, Does the U.S. System of Taxation on Multinationals Advantage Foreign Acquirers? (January 15, 2015), available at SSRN.

Did Burger King submit to acquisition by a Canadian donut chain for tax reasons? Or, at least, once Burger King and Tim Hortons decided to merge, did they choose to have a Canadian parent for tax reasons? A recent empirical study by Andrew Bird, Alexander Edwards and Terry Shevlin suggests that one tax factor—the existence of “locked out” offshore earnings—increases the likelihood that a non-U.S. acquirer will acquire a U.S. target. Bird, Edwards and Shevlin analyze thousands of merger transactions, without regard to whether the transactions might be labeled “inversions.” Their paper contributes to the considerable literature that tests the idea that accounting and tax disparities affect firm prices and transaction decisions.

Bird, Edwards and Shevlin examine several thousand public company firms with a parent corporation incorporated in the United States, for example under Delaware law. Each of the firms in the sample was acquired between 1995 and 2010. The paper considers the possibility that these target U.S. firms might have been acquired by U.S. or non-U.S. acquirers. Bird, Edwards and Shevlin find that when a U.S.-parented target corporation has more offshore “locked-out earnings,” the target firm is more likely to merge with a non-U.S. acquirer rather than a U.S. acquirer.

The concept of “locked-out earnings” has meaning in both tax law and tax accounting vocabularies. From a U.S. income tax law perspective, the presence of “locked-out earnings” generally means that a firm has achieved a low tax rate on non-U.S. earnings housed in non-U.S. subsidiaries of a U.S. parent. The earnings are “locked-out” because the U.S. parent would have to pay significant residual U.S. corporate income tax (as well as, perhaps, non-U.S. withholding tax) upon a dividend of the earnings to the U.S. parent. Such a residual U.S. tax would be reduced by credits for foreign income taxes paid, but a firm that has achieved a low tax rate on non-U.S. earnings will generally not have significant foreign tax credits available.

Financial accounting for taxes provides a required disclosure related to locked-out earnings. A firm can designate and report earnings that are indefinitely reinvested in a foreign jurisdiction as permanently reinvested, or PRE. A firm need not record any income tax expense with respect to PRE, on the theory that the designated earnings are earmarked for offshore investment and will never come home. Other work has shown that both tax and nontax incentives drive PRE designation. In other words, there is some overlap between PRE in accounting and the idea of locked-out earnings in tax, but the overlap is not complete.

Having a non-U.S. parent—rather than a U.S. parent—alleviates both the tax law and the accounting problems associated with locked-out earnings. From a tax law perspective, it may be possible for a firm to repatriate pre-transaction earnings without residual U.S. tax using a “hopscotch loan” or other “out-from-under” technique. (The Obama administration recently promised regs that would treat hopscotch loans as deemed dividends, but only for a firm that had engaged in a transaction treated as an inappropriate inversion.) Also, future non-U.S. earnings should not produce the tax-lockout problem.

A favorable accounting result follows from favorable tax results, to the extent available. In other words, if there is no residual tax upon the repatriation of earnings, a foreign parent need not report a tax expense upon a distribution of foreign earnings.

Bird, Edwards and Shevlin use three proxies for locked-out earnings. One is the PRE disclosed in a target firm’s financial statement footnotes. A second is a binary PRE indicator variable that equals 1 if there is any disclosure that PRE exists. A third is a repatriation cost measure derived from the difference between U.S. corporate tax that would be imposed on foreign income (at the U.S. statutory rate) and current foreign income tax expense already paid (to account for foreign tax credits).

They find that the more PRE a U.S. firm has, the greater the likelihood that the firm will be acquired by a non-U.S. firm. A one percentage point increase in PRE translates to a 0.58 percentage point increase in the likelihood of a foreign acquirer. A one percentage point increase in the repatriation cost measure proxy for locked-out earnings has a smaller effect—it translates to a 0.02 percentage point increase in the likelihood of a foreign acquirer. Both are highly significant, at the 1% level, meaning that there is a 99% probability that the relationship described in the sample of firms also applies for a larger population. When the authors control for the existence and proportion of foreign earnings at a firm, a one percentage point increase in PRE translates to a 0.36 percentage point increase in the likelihood of a foreign acquirer, with significance at the 5% level. These changes compare to 23% overall likelihood of a non-U.S. acquirer for a U.S. target with non-U.S. operations.

The authors also divide non-U.S. acquirers into two groups according to whether they operate under territorial systems, meaning that the jurisdiction of incorporation only taxes domestic income; or worldwide systems, meaning that the jurisdiction of incorporation taxes (at least in theory) both domestic and foreign income. They find that the observed correlation between locked-out earnings and the likelihood of non-U.S. acquisition is driven by non-U.S. firms incorporated in territorial jurisdictions. A one percentage point increase in PRE translates to a 0.32 percentage point increase in the likelihood of acquisition by a territorial non-U.S. firm, but lacks a statistically significant correlation with the likelihood of acquisition by a worldwide non-U.S. firm.

This work has relevance for international tax policy because it suggests a general reason why non-U.S. acquirers may have an advantage over U.S. acquirers for some U.S. target firms. Bird, Edwards and Shevlin do not claim that their results show that accounting and tax considerations cause firms to seek an acquirer; the paper’s sample does not include any control group of firms that did not merge at all. But their results may have relevance for proposals to adopt territoriality for the U.S. system.

More generally, their results emphasize the importance of working out how to tax non-U.S. parented firms with U.S. subsidiaries. This project has long been a sideshow in the U.S. The paradigm case in regulations, white papers and case law features the U.S. parent of a multinational group. Earnings stripping legislation has been stalled for years. This project needs to move forward in order to reach appropriate results for non-U.S. parented multinationals, including those that result from acquisitions described in the Bird, Edwards and Shevlin paper.

Cite as: Susan Morse, Non-U.S. Acquirers: Clients for U.S. Targets’ “Locked-Out” Earnings?, JOTWELL (April 3, 2015) (reviewing Andrew Bird, Alexander Edwards, & Terry J. Shevlin, Does the U.S. System of Taxation on Multinationals Advantage Foreign Acquirers? (January 15, 2015), available at SSRN), http://tax.jotwell.com/non-u-s-acquirers-clients-for-u-s-targets-locked-out-earnings/.

So Who, at the End of the Day, Owns Google (or Apple, or Microsoft, or Pfizer…)?

Chris William Sanchirico, As American as Apple Inc.: International Tax and Ownership Nationality, 68 Tax. L. Rev. __ (forthcoming), available at SSRN.

As I was sitting down to draft this review of Chris Sanchirico’s paper, I ran a simple search on Google News: “‘U.S. Companies’ and Tax”. Here are some of things I learned skimming through search results returned by major news outlets: “U.S. Companies” now stash over $2 trillion overseas in order to avoid taxes (NBCNews, Nov. 12, 2014); “U.S. Companies” use mergers to shift their legal address to low-tax jurisdictions in a strategy known as “inversion” in order to reduce their U.S. tax bill (Bloomberg, Oct. 28, 2014); and, one of Congress’ top priorities for 2015 is a tax reform aimed at “helping” “U.S. Companies” avoid the U.S.’s “highest-in-the-world corporate tax rates”, in order to grow the economy (CNBC, Nov. 17, 2014).

Clearly, the taxation of “U.S. Companies” plays a major role in public discourse. Roughly speaking, the two sides of the debate can be outlined as follows: U.S. multinational corporations either pay too much (because our tax system is not competitive compared with the rest of the world), or too little (because our tax system is riddled with loopholes). We need to reform our tax system so “U.S. Companies” are at par with their foreign competitors; or, we need to tighten our tax rules so as to make sure that “U.S. Companies” share the burden. While political views differ, the terms of the debate seem clear. Whichever side of the debate one takes, something must be done about how we tax “U.S. companies.”

Sanchirico, however, questions the core terms of the debate: “When we speak of ‘U.S. multinationals,’ what do we mean by ‘U.S.’? More specifically, to what extent are these ‘U.S.’ companies owned by non-U.S. investors?” Sanchirico’s ultimate answer is quite a shocker: we have no idea what we are talking about when we speak of “U.S. Companies,” at least in terms of who owns these companies.

Sanchirico’s argument is especially important if we assume (as most tax scholars do) that corporations are not in-and-of-themselves a target of tax policy-making. Rather, when we debate how to tax “U.S. corporations,” we really debate the effects to tax policy on the ultimate corporate stakeholders, which are in turn often assumed to be the corporate shareholders. It thus makes no sense speaking of “U.S. companies” unless we can establish that such companies are indeed ultimately beneficially owned, at least to a significant extent, by U.S. individuals. The standard academic response to such conundrum is the “home country bias” according to which equity investors tend to disproportionately invest in domestic corporations.

Sanchirico does an excellent job demonstrating the questionable applicability of home country bias effects to corporations that in popular view are perceived to be “U.S. Companies.” His work lays open the empirical possibility that in today’s economic environment, multinationals with a U.S.-incorporated parent should not be viewed as inherently “U.S.” and that the significant presence of U.S. multinationals such as Apple and Microsoft overseas helps overcome home-bias tendency. Perhaps it is now unlikely that a British investor would shy away from Apple (which is very much present in the U.K. market) just because Apple is not “British”.

Following this hypothesis, Sanchirico executes a meticulous research into databases that are used (or could potentially be used) to identify the nationality of ultimate beneficial owners of U.S. equities. He finds that all of the databases suffer from limitations that prevent us from positively identifying the nationality of most beneficial owners in U.S.-traded equities. Most importantly, all datasets inherently suffer from “fund opaqueness” problem. That is, under most reporting requirements, a “fund” (which generally refers to an institutional investor, or an account held with a financial institution) is reported as the owner of equities. Using these datasets, we cannot tell who the beneficial owners are. At best, current data offers us knowledge of companies’ ownership by intermediaries, or equity ownership in U.S. intermediaries (one of my favorite parts in the article is a chart showing 15 major equity owners in Google Inc., all of which are financial intermediaries).

It is difficult to overstate the importance of Sanchirico’s findings to current tax-policy debate. Our tax-policy discourse is very much attached to national identities, with the beneficiaries of so-called U.S. corporations assumed to be U.S. individuals. In our globalized environment, Sanchirico proves such assumption to be, at the minimum, problematic. Would we really care if, say, Pfizer (a “U.S. company”) is outbid by Teva Pharmaceuticals (an “Israeli company”) when competing for an investment opportunity overseas if it turns out that Pfizer is majority-owned by non-U.S. investors? Can the U.S. tax systems be declared “uncompetitive” under such a set of facts? If so, uncompetitive relative to whom? How much should we care about Apple’s tax-avoidance strategies, if it turns out that Apple is beneficially owned by foreign investors? What would be the normative basis, under such circumstance, to force additional U.S. tax burden on Apple’s earnings?

One might challenge the assumption that nationality of companies should derive only from the nationality of their equity owners. To the extent we tax corporations as a backstop for individual taxation of shareholders (a prevalent theory in corporate taxation), Sanchirico’s starting-point assumption makes sense. However, scholars have suggested multiple other theories for taxing corporations. In such contexts, “nationality” of corporations could mean something other than the nationality of shareholders. For example, under one common theory, corporations are taxed in order to regulate managers. If this theory prevails, one might argue that the nationality of corporations should be determined based on the nationality of corporate managers, not shareholders.

Nonetheless, at the end of the day Sanchirico’s article points to a core terminological failure in our tax reform discourse. The outcome ought to be paradigm shifting, as no policy discussion on the taxation of U.S. companies can make sense as long as we fail to recognize the policy targets of the discussion. Sanchirico’s paper should serve as a launching-pad for any future discussion on U.S. international tax reform.

Cite as: Omri Marian, So Who, at the End of the Day, Owns Google (or Apple, or Microsoft, or Pfizer…)?, JOTWELL (March 3, 2015) (reviewing Chris William Sanchirico, As American as Apple Inc.: International Tax and Ownership Nationality, 68 Tax. L. Rev. __ (forthcoming), available at SSRN), http://tax.jotwell.com/so-who-at-the-end-of-the-day-owns-google-or-apple-or-microsoft-or-pfizer/.

Does Punishment Work (at Least in International Tax)?

Niels Johannesen and Gabriel Zucman, The End of Bank Secrecy? An Evaluation of the G20 Tax Haven Crackdown, 2014 Am. Econ. J. Econ. Policy 65.

The OECD is currently undertaking a major study of virtually every significant issue confronting the international tax regime through its “base erosion and profit shifting” (BEPS) project. Among the proposals for reform include the familiar call for increased penalties on non-cooperative states. In fact, punishment has served as a core feature of virtually every modern attempt to combat tax competition.

But does punishment really work in this context? Niels Johannesen and Gabriel Zucman address precisely this question in their paper The End of Bank Secrecy? An Evaluation of the G20 Tax Haven Crackdown. The best way to describe the project is to quote the abstract:

During the financial crisis, G20 countries compelled tax havens to sign bilateral treaties providing for exchange of bank information. Policymakers have celebrated this global initiative as the end of bank secrecy. Exploiting a unique panel dataset, our study is the first attempt to assess how the treaties affected bank deposits in tax havens. Rather than repatriating funds, our results suggest that tax evaders shifted deposits to havens not covered by a treaty with their home country. The crackdown thus caused a relocation of deposits at the benefit of the least compliant havens.

This paper provides an extremely important and timely contribution to the international tax literature. Anecdotal evidence about the effectiveness of punishment has been mixed to date, and there has been little empirical data directly on the question. Further, the question taps into a larger debate over the underlying, root causes of tax competition more generally. By providing empirical data directly on this question, Johannesen and Zucman move the debate forward in an extremely valuable way.

As background, the traditional approach to tax competition provides that cooperation over tax matters benefits every country of the world. An observed lack of cooperation, therefore, must represent some form of institutional failure (whether it be political economy, irrationality, etc.). Such failure, in turn, justifies punishment in response. Under this theory, every country added to the cooperative list as a result would move the world closer to the ideal result.

A competing theory has begun to emerge, however. Under this “holdout” theory, it is assumed that cooperation—while in the best interest of the worldwide regime as a whole—is not necessarily in the best interest of every individual country. Rather the holdout problem arises when the benefits to any one country of holding out increase as other parties agree to cooperate. Suppose the Cayman Islands ceased to be tax haven tomorrow. Would that make it more or less valuable for Bermuda to remain a tax haven? The punishment approach would say it becomes less valuable, while the holdout theory would say it becomes more valuable.1

Johanessen and Zucman provide a unique data set to analyze precisely this question. More specifically, they ask whether punishing certain countries for adopting bank secrecy resulted in less overall use of bank secrecy—consistent with the punishment theory—or simply in the shifting of assets to other bank secrecy jurisdictions—consistent with the holdout theory. They find compelling evidence that assets simply shifted to other bank secrecy jurisdictions.

This is potentially a ground-shaking finding. The punishment theory has, for the most part, served as the intellectual basis for international tax policy over the past two decades. Real-world successes were pointed to in support of the theory while failures were explained as the result of inadequate measures. Either way, more (or differently tailored) punishment was typically justified.2 If Johannesen and Zucman are correct, however, this story no longer holds. In fact, taken to its logical extreme, their findings could undermine the punishment theory as the intellectual basis for international tax policy altogether. Hopefully, as a result this paper can help move the policy debate away from the punishment theory and towards the holdout theory, ultimately resulting in a more efficient and effective international tax regime.

By itself, this would be a significant contribution. The holdout theory, if true, would mean that the world faces a collective action problem in which the primary issue would be whether cooperation from every country in the world was possible.3 Conversely, increasing cooperation by a handful of countries—one of the stated goals of BEPS—could potentially make the regime worse off for everyone.4 To this end, Johannesen and Zucman argue that “[f]rom a normative viewpoint, our paper thus lends support to the idea … that a ‘big bang’ multilateral agreement should be preferred to the current sequential approach.” While this may be correct as a theoretical matter, it is difficult to imagine every country of the world meeting in one place and agreeing to a new, comprehensive international tax regime. So where does that leave things?

Although Johannesen and Zucman support the call for a multilateral treaty, their results could also support side payments, or a multinational tax institution, or a number of other legal structures.5 Ultimately, then, I believe this paper highlights the need for increased dialogue between public finance and legal experts in this area, especially given the unique opportunity to revisit all of these issues through BEPS. Economists are good at measuring and quantifying issues, and providing disciplinary rigor to analyzing difficult questions. Lawyers know how to implement policy, how to build institutions, and how to anticipate taxpayer responses. Both are necessary to build a real-world regime, and each can learn from the other. Hopefully, Johannesen and Zucman, as part of a larger project, can help further this process.

  1. See Adam H. Rosenzweig, Why Are There Tax Havens?, 52 Wm. & Mary L. Rev. 923 (2010). []
  2. For a survey, see Susan C. Morse, Tax Compliance and Norm Formation Under High-Penalty Regimes, 44 Conn. L. Rev. 675 (2011). []
  3. See Adam H. Rosenzweig, Harnessing the Costs of International Tax Arbitrage, 26 Va. Tax Rev. 555 (2007). []
  4. citing Elsayyad and Konrad, Fighting multiple tax havens, 86 J. of Int’l Econ. 295 (2011). []
  5. See Adam H. Rosenzweig, Thinking Outside the (Tax) Treaty, 2012 Wis. L. Rev. 717. []
Cite as: Adam Rosenzweig, Does Punishment Work (at Least in International Tax)?, JOTWELL (January 30, 2015) (reviewing Niels Johannesen and Gabriel Zucman, The End of Bank Secrecy? An Evaluation of the G20 Tax Haven Crackdown, 2014 Am. Econ. J. Econ. Policy 65), http://tax.jotwell.com/does-punishment-work-at-least-in-international-tax/.

The IRS as Tax Law Nonenforcer

Lawrence Zelenak, Custom and the Rule of Law in the Administration of the Income Tax62 Duke L.J. 829 (2012).

In a recent essay, Custom and the Rule of Law in the Administration of the Income Tax, Larry Zelenak examines what he calls “customary deviations,” or “established practice[s] of the tax administrators . . . that deviat[e] from the clear dictates of the Internal Revenue Code.”  Even though the IRS makes decisions every day about when not to enforce the tax law, tax scholarship does not typically examine this phenomenon systematically. By focusing on an aspect of IRS nonenforcement, Zelenak shines a much needed light on the topic. The essay, and the topic generally, should garner the attention of tax scholars, as well as scholars of enforcement discretion more generally.

Like other administrative agencies as well as prosecutors, the IRS has to make decisions all the time about when not to enforce the tax law. These decisions raise important questions about the legitimacy of different types of decisions not to enforce the tax law. For instance: Is it more or less legitimate for the IRS to decide not to enforce the law through a clear, customary deviation, or through a more opaque policy?  If the IRS is somehow curtailed in its ability to use customary deviations, what alternatives might it use and would these be better or worse?  By raising questions about customary deviations, Zelenak’s essay provides a jumping off point for a broader examination of tax law nonenforcement.

Zelenak’s story of customary deviations begins with the IRS’s nonenforcement of the tax law with respect to the personal use of frequent flier miles generated by an employer’s provision of travel. Zelenak explains that, despite the fact that the vast majority of commentators have assumed the statutory taxability of such miles, the IRS indicated that it “will not assert that any taxpayer has understated his federal tax liability by reason of the receipt or personal use of frequent flyer miles . . . attributable to the taxpayer’s business or official travel.” The implication of this example is broader than the example suggests. As Zelenak describes it, the IRS’s statement is a bald acknowledgement that it will not enforce the tax law, raising important questions about tax administration.

For Zelenak, customary deviations highlight an insoluble tension in tax administration. Customary deviations are often well-advised administrative responses to real enforcement difficulties and can help create more efficient administration of the tax system. And yet, Zelenak contends that such deviations threaten the rule of law. Zelenak makes the rule of law point most forcefully by arguing that the acceptance of customary deviations regarding frequent flier miles (and other customary deviations, such as exclusions for employee fringe benefits and deductions for Scientologists for “auditing” services) may have emboldened the IRS to provide customary deviations that he believes present a greater threat to the rule of law. The deviations that he believes present a greater threat to the rule of law include the IRS’s controversial declarations limiting the application of the loss-disallowance rules of section 382 of the Code in connection with bank acquisitions (at the time of bailout of the financial industry) and in connection with the Treasury Department’s sale of General Motors shares to the public.

In all of these cases, Zelenak laments the difficulty in challenging customary deviations. He usefully explores how the pro-taxpayer nature of customary deviations and limitations on third-party taxpayer standing leave little room for outsiders to step in and prevent customary deviations from going too far. Zelenak leaves the reader with the sense that customary deviations can in some cases be desirable, in some cases problematic, but in all cases difficult to do anything about as a result of limitations on taxpayer standing and the real threat that allowing standing to challenge the deviations may pose to the administrability of the tax system. Zelenak’s most concrete proposal is for “Congress to enact a new Code provision specifically authorizing the Treasury Department to issue regulations narrowing the statutory definition of gross income with respect to non-cash benefits received outside of an employment context, whenever the IRS decides that administrative concerns make such a narrowing advisable,” and that “Congress might decide to give the Treasury Department similar authority to revise by regulation other specified Code sections . . . .”  Zelenak leaves aside a full exploration of potential problems with this proposal. Rather, his contribution is to expose the conundrum of customary deviations, which form a subset of the broader set of strategies that the IRS uses to manage an enforcement mandate that exceeds its capacity. His essay thus points to the broader problem of the IRS’s inevitable enforcement discretion and what, if anything, should be done about it.

Cite as: Leigh Osofsky, The IRS as Tax Law Nonenforcer, JOTWELL (December 17, 2014) (reviewing Lawrence Zelenak, Custom and the Rule of Law in the Administration of the Income Tax, 62 Duke L.J. 829 (2012)), http://tax.jotwell.com/the-irs-as-tax-law-nonenforcer/.

Keeping Us Honest about the Timing Flaws in the Income Tax

Daniel I. Halperin & Alvin C. Warren Jr., Understanding Income Tax Deferral, Tax L. Rev. (forthcoming), available at SSRN.

We all do it once in a while. In the haste of trying to make a point in class, or in a hurried comment to the press, we overstate the effect of the failure of a tax law rule to take into account the time value of money. “The effect of deferral of income,” we may boldly assert, “is the exemption of the earnings on the amount deferred.” A recent short essay by Dan Halperin and Al Warren entitled Understanding Income Tax Deferral should help us all stay a bit more accurate when we make these claims. As Halperin and Warren point out, although in some limited circumstances the benefit of deferral can be the exemption of the earnings on the amount deferred, often the effect of an apparent deferral is more limited and more nuanced. In some cases, timing flaws produce only reduced taxation, not full exemption, while in other cases rules that seem to involve timing flaws merely shift income to other taxpayers or to other taxing jurisdictions. Halperin and Warren remind us that it can be very important to be able to distinguish between these results. This paper will displace Halperin’s 1986 classic in my must-read recommendations for beginning teachers of tax.

There is little that is actually new in the essay. However, it is a much-needed and succinct guide to the principles involved when considering the effect of timing in the rules defining the income tax base. Thirty years ago, when interest rates were high, correcting the timing mistakes embedded in the income tax law was a high policy priority. For example, the original issue discount rules were tightened and applied to many more transactions (in sections 1271, 1274 and 7872) and the possibility of accruing costs before payment were substantially curtailed (through various changes in the taxation of retirement savings and in sections 461(h)). In this era, the principles Halperin and Warren newly examine here became a mainstay of tax policy analysis. No one participating in policy discussions could afford not to understand them.

But in the recent era of extremely low interest rates, these timing issues may seem hardly worth the effort it takes to learn them with any rigor. And these principles have become more sloppily invoked in policy arguments.

Despite low interest rates, a thorough understanding of time-value interactions remains crucial to understanding current tax policy debates. Without them, one cannot understand the ways in which the income tax may continue to evolve to become more like a consumption tax. Nor can one fully understand the stakes in revising the US approach to taxing the offshore earnings of multinationals, which is the subject of a companion primer written by Warren. It is in these discussions that the failure to pay close attention to the application of the underlying time value principles can lead to exaggeration and inaccuracy.

This short piece thus outlines succinctly what is—and what is not—at stake when tax rules fail to reflect the exact time at which a value that normatively should be treated as income is created. The familiar bottom line is that when an item of income excluded (or, more familiarly a unwarranted deduction is granted), the resulting reduction in income tax due is the same as if the income on the erroneously-accounted-for amount were explicitly made exempt. Halperin and Warren are careful to be precise about the conditions that must be met in order for this proposition to hold in the real world: the initial rate of return must remain available for all re-investments of tax savings, the tax savings must be available for such immediate reinvestment when these savings first arise and on each iteration of reinvestment, and the tax rate must remain constant. (Their assumption is actually stated in a slightly weaker way, that there must be “enough taxable income to absorb the deduction.” The difference is trivial in the abstract, but could be crucial in real tax policy debates. For instance, because withholding of wage income makes immediate reinvestment difficult, the analysis may not apply when the only income to be offset is wage income.) They emphasize that if the initial rate of return cannot be replicated on the reinvestment, the return on the original investment is exempt but only to the extent of this lower return. Halperin and Warren also emphasize the similarly overlooked point that the benefit of the deferral can also be less than the value of an exemption if the return on the tax saved by the deferral is not itself subject to deferral.

After clarifying these simple but often overlooked variations of the partial (and occasional full) exemption of returns through deferred inclusion or inappropriate deduction, Halperin and Warren point out the relationship of this phenomenon (which they refer to as “pure deferral”) to what they somewhat reluctantly refer to as “counter-party” deferral. In such cases, a benefit is derived from the timing of the tax treatments only because of the tax treatment of another potential taxpayer during the period of deferral.

An individual taxpayer and his or her IRA provide one example of a pair of “counter parties”; a U.S. parent corporation and its non-U.S. subsidiary provide another example. If tax rates remain constant, there is a benefit to a deductible IRA only because the earnings within the IRA are not taxed; as is well known, this benefit is the same as if the deduction were not allowed and the earnings within the IRA were not taxed. Similarly, there is a tax benefit to the deferral of the offshore income of multinationals only because this leaves the earnings on the funds in non-U.S. subsidiaries not taxed at US rates. In other words if tax rates remain the same, the tax avoided upon contribution (or, in the case of US multinationals, deferral) has the same present value as the tax to be paid upon withdrawal from the IRA (or repatriation). The tax play turns on the rules governing the taxation of the fund during the period of deferral.

Put still another way, a deduction in time 1 will be entirely and exactly offset by an inclusion of that amount plus the return on that amount in time 2. Note, however, that the additional tax imposed at time 2 can only be either an amount that undoes the earlier benefit, or a tax on the return during the interim time period itself; it cannot be both. Counter-party deferral amounts to exemption only when there has been no other tax on the return in the interim.

The difference between the two phenomena distinguished by Halperin and Warren can be confusing, because many examples that are asserted in some situations as if they involved pure deferral actually involve only counterparty deferral. The difference is not as well-specified by Halperin and Warren as it might be, but the gist of the difference is whether an amount is completely omitted from the income tax base of all of the parties to the transaction, or whether it is only effectively moved temporarily from one taxpayer to another, and then restored to the original taxpayer. In “pure deferral”, for example in the case of accelerated depreciation, the amount in question is initially omitted from the tax base and will reappear only as the same nominal value; in “counter-party deferral”, the amount will reappear increased by a rate of return, as in the case of tax-preferred savings accounts.

The recent attempt of Halperin and Warren to lay out with some precision what is at stake in the various phenomena loosely called “deferral” is a welcome contribution and should become a go-to primer. The essay includes the math critical to the analysis, but in a way that does not require the reader to be able to reproduce it in order to get the full message. It is also a useful review of the literature produced by tax academics in law schools (significantly by Halperin and Warren themselves) that connects the relatively simple financial principles regarding the time value of money with the on-the-ground tax policy debates in which they properly appear.

Cite as: Charlotte Crane, Keeping Us Honest about the Timing Flaws in the Income Tax, JOTWELL (November 19, 2014) (reviewing Daniel I. Halperin & Alvin C. Warren Jr., Understanding Income Tax Deferral, Tax L. Rev. (forthcoming), available at SSRN), http://tax.jotwell.com/keeping-us-honest-about-the-timing-flaws-in-the-income-tax/.

Evaluating the Efficacy of Nonmonetary Tax Penalties

Joshua D. Blank, Collateral Compliance, 162 U. Pa. L. Rev. 719 (2014).

Monetary penalties for noncompliance are a routine feature of the tax laws. The tax literature includes extensive debate over different ways of structuring those penalties to improve tax compliance and eliminate the tax gap. In Collateral Compliance, Josh Blank shifts his gaze beyond that debate to examine what he labels “collateral tax sanctions”—nonmonetary penalties that federal and state governments impose, in addition to the monetary ones, for failing to comply with the tax laws.

One rather dramatic example of a collateral tax sanction comes from the Supreme Court’s 2012 decision in Kawashima v. Holder, in which the Court upheld a Bureau of Immigration Appeals interpretation of the Immigration and Nationality Act that treated willfully filing a false tax return as an “aggravated felony” and, thus, a deportable offense for non-citizens. Less spectacularly, perhaps, states regularly suspend driver’s licenses, professional licenses, liquor licenses, or hunting licenses for nonpayment of taxes. Congress has considered legislation revoking passports and denying FHA-insured mortgages as punishment for tax delinquency.

Plenty of articles examine the pros and cons of one collateral tax sanction or another. Blank’s article is unique for his effort to step back and consider collateral tax sanctions more systematically. He explores in some depth why collateral tax sanctions sometimes succeed where monetary tax penalties fail. He also proposes some basic principles for structuring collateral tax sanctions to maximize their effectiveness as a mechanism for encouraging tax compliance.

Blank theorizes first that, for some taxpayers, monetary penalties are indistinguishable from the underlying tax obligation, and thus no more likely to inspire the delinquent taxpayer to pay up. By contrast, a driver’s license, a passport, or a hunting license may be more valued and significant. The prospect of losing the right to drive, travel, or hunt may be more personally painful or even economically costly than paying monetary penalties. Monetary tax penalties are private, while collateral tax sanctions are often public. People may want to avoid the embarrassment of explaining a license suspension to friends, family, or potential clients. Collateral tax sanctions also reinforce the connection between paying taxes and receiving government benefits. The simple salience of collateral tax sanctions also presents potential drawbacks, including potential spillover consequences, perceptions of unfairness, horizontal equity issues, and privacy concerns. Governments could easily go overboard in imposing collateral tax sanctions, creating more harm than good.

Recognizing the drawbacks as well as the effectiveness of collateral sanction, Blank proposes three principles for their development and application. First, he contends that governments should only use collateral tax sanctions to enforce tax rules that are clear and easily understood in advance (like filing deadlines) rather than tax standards, the ex ante application of which may be more ambiguous (like the economic substance doctrine). Second, Blank suggest that tax rather than nontax laws and administrators should define the scope of the tax offenses that give rise to collateral tax sanctions, to protect the integrity of the tax laws, and also to enable tax authorities to understand the full range of consequences for tax noncompliance and use that knowledge to influence taxpayer behavior. Third, Blank counsels proportionality; the punishment should fit the crime.

Blank illustrates his three principles by evaluating the advisability of collateral tax sanctions in a few different contexts. For example, suspending a professional license when a state revenue department determines that an individual has failed to file a tax return would satisfy all three of Blank’s principles. By contrast, deporting otherwise law-abiding, long-time permanent residents like the Kawashimas based on a determination by immigration officials that willfully failing to file a tax return represents “fraud or deceit” would be problematic under Blank’s approach.

Finally, Blank suggests that collateral tax sanctions will only work if taxpayers know about them. He offers suggestions to government officials for publicizing collateral tax sanctions to maximize their effectiveness.

In any tax system that relies on taxpayers to self-report and pay their taxes, noncompliance will always be a problem searching for and needing not just one but many solutions. Blank offers a persuasive case, some cautionary notes, and a thoughtful proposal for developing and evaluating collateral tax sanctions as part of the compliance toolkit.

Cite as: Kristin Hickman, Evaluating the Efficacy of Nonmonetary Tax Penalties, JOTWELL (October 21, 2014) (reviewing Joshua D. Blank, Collateral Compliance, 162 U. Pa. L. Rev. 719 (2014)), http://tax.jotwell.com/evaluating-the-efficacy-of-nonmonetary-tax-penalties/.

Next Up, Incest

Anthony C. Infanti, Big (Gay) Love: Has the IRS Legalized Polygamy?, N.C.L. Rev. Addendum (forthcoming, 2014), available at SSRN.

Gay marriage opponents love to fear monger about the slippery slope of extending marriage beyond the legal union between one man and one woman. They prophesy that if we allow marriage between two men or two women, we will descend into a Gomorrah of incest, adultery, polygamy, and animal love. In his essay, Big (Gay) Love: Has the IRS Legalized Polygamy?, Anthony Infanti makes subversive use of this repugnant meme to advance his view that tax results should not depend on marriage in the first place.

Infanti’s argument focuses on an analysis of Revenue Ruling 2013-17 (the Ruling), which recognizes same-sex marriages for federal tax purposes. Issued in 2013, after the U.S. Supreme Court invalidated section three of the federal Defense of Marriage Act, the Ruling announces the IRS’s adoption of a general interpretive rule that “for Federal tax purposes … recognizes the validity of a same-sex marriage that was valid in the state where it was entered into, regardless of the married couple’s place of domicile.” Infanti interprets the Ruling to apply to a limited subset of same-sex marriages, in contrast to what he calls the “alternative interpretation” of the Ruling, which reads the Ruling more expansively to cover a larger number of same-sex marriages. Infanti claims that under alternative interpretation of the Ruling, the IRS would also have to recognize the validity of plural marriages.

The crux of the difference between Infanti’s interpretation of the Ruling and the alternative interpretation relates to the treatment of two categories of same-sex marriage, migratory marriage and evasive marriage. A migratory marriage is one in which a couple lives and marries in one state and later moves to another. An evasive marriage is one in which a couple travels to and marries in another state in order to evade a marriage prohibition in their home state. (Infanti identifies two additional categories of same-sex marriage, visitor marriage and extraterritorial marriage, but these are peripheral to his argument.)

Infanti argues the IRS intended in the Ruling to recognize the validity of migratory marriages but not evasive marriages. He reasons that because the Ruling recognizes the validity of same-sex marriages “valid in the state where . . . entered into,” it does not extend to evasive marriages that are invalid under choice-of-law rules. (An evasive marriage is invalid under choice-of-law rules if a court defers to the couple’s state of domicile to determine whether a marriage is valid and finds that the marriage violates a strong public policy of the domicile state.) The alternative interpretation, espoused by Professors Patricia Cain and Will Baude, among others, is that the Ruling recognizes the validity of both migratory and evasive marriages.

Infanti argues that if the alternative interpretation is correct, then the IRS would also have to recognize plural marriages. To show this, Infanti develops a hypothetical involving a same-sex couple, A and B, domiciled in State X, who enter into an evasive marriage—that is, in order to evade State X’s prohibition on same-sex marriage, they travel to and marry in State Y and then return home to State X. Under the alternative interpretation of the Ruling, the IRS would recognize the marriage for federal tax purposes. However, under choice-of-law principles, if State X has a strong public policy against same-sex marriage, the marriage would be invalid for state law purposes. The marriage would be a nullity for state law purposes, which means that A and B could then enter into marriages with other people that are valid under state law. These other marriages would also have to be recognized as valid by the IRS, creating the possibility that the IRS would recognize plural marriages for federal tax purposes.

Provocative title notwithstanding, Infanti’s argument is a reductio ad absurdum: He does not believe the IRS actually intended to recognize plural marriages for tax purposes, and he thinks the alternative interpretation of Ruling is defective on the grounds that it is implausible, inadvisable, and would create a federal tax law of marriage. Nor does Infanti aim to stake out a position on whether plural marriages ought to be recognized under state or federal law. Rather, his argument is intended to illustrate the legal uncertainty and ambiguity that continue to plague same-sex couples even in a context where the IRS purports to provide certainty and clarity.

Infanti is a leading critical tax theorist who has challenged orthodoxies on subjects ranging from tax equity to international development norms to the definition of the family. In this essay and the prior work on which it builds, he demonstrates he is an equal-opportunity tax crit: He challenges the mainstream view of progressive scholars and LGBT activists who advocate for extending the privilege of conventional marriage to same-sex couples. Infanti argues that achieving equality between same-sex couples and heterosexual married couples is an elusive, perhaps unattainable goal. Moreover, he believes the goal of equal privilege to be misguided because it disregards the unequal treatment of other family formations. Infanti instead advocates for a tax system based on individual filing that recognizes all economically interdependent relationships. For readers familiar with Infanti’s scholarship, Big (Gay) Love is a terrific addition to his body of work; for new readers, it is a portal into Infanti’s critical sensibility. Either way, I highly recommend it.

Cite as: Lily Kahng, Next Up, Incest, JOTWELL (September 17, 2014) (reviewing Anthony C. Infanti, Big (Gay) Love: Has the IRS Legalized Polygamy?, N.C.L. Rev. Addendum (forthcoming, 2014), available at SSRN), http://tax.jotwell.com/next-up-incest/.

An Empirical Test of Public Choice Theory

Susannah Camic Tahk, Public Choice Theory & Earmarked Taxes, N.Y.U. Tax L. Rev. (forthcoming, 2015), available at SSRN.

In 1980, James Q. Wilson, in The Politics of Regulation, predicted that laws with diffuse costs and concentrated benefits would be relatively easy to enact, but that laws with concentrated costs and diffuse benefits would be relatively hard to enact and, once enacted, hard to maintain. This hypothesis, one of the pillars of public choice theory, has long been asserted without empirical verification. Indeed, in 1994, Donald Green and Ian Shapiro, in Pathologies of Rational Choice Theory, challenged the willingness of theorists to accept such unverified predictions as true: “The discrepancy between the faith that practitioners place in rational choice theory [of which public choice theory is a branch] and its failure to deliver empirically warrants closer inspection of rational choice theorizing as a scientific enterprise.” In Public Choice Theory & Earmarked Taxes, Susannah Camic Tahk provides the first rigorous empirical support for Wilson’s hypothesis.

Her study explores the histories of 1497 state-level earmarked taxes between 1997 and 2005. Earmarked taxes, in general, produce more concentrated benefits than taxes the proceeds of which flow into a state’s general fund. Thus, we would expect earmarked taxes to perform strongly as revenue generators. And, indeed, Tahk finds that the earmarked taxes in her sample raised 58.39% more revenue in 2005 than in 1997—a larger percentage increase than any major federal tax over the same period.

Tahk codes each tax in her sample for concentration of costs on a scale of 0 to 3 – 3 for the most concentrated, 0 for the most diffuse—and for concentration of benefits. Subtracting the benefit score from the cost score produces what she calls a “cost/benefit distribution” score for each tax, ranging from -3 to +3. A tax with a low cost/benefit distribution score—for example, New Hampshire’s tax on business profits earmarked for education—has diffuse costs and concentrated benefits. Public choice theory predicts that such a tax should be relatively easy to enact and maintain. A tax with a high cost/benefit distribution score—for example, Nevada’s tax on specific minerals earmarked for local governments and general debt service—has concentrated costs and diffuse benefits. Public choice theory predicts that such a tax should be relatively hard to enact and maintain.

She then tests the relationship between each tax’s score and its change in revenues between 1997 and 2005, controlling for state GDP, state GDP per capita, and state revenue per capita, and finds a statistically significant inverse relationship between the two. Taxes with diffuse costs and concentrated benefits raised more revenue over time; taxes with concentrated costs and diffuse benefits, less. Bingo! Wilson’s hypothesis confirmed.

It is hard to overstate the importance of this accomplishment. Tahk has identified a body of rules—earmarked state taxes—with respect to which costs and benefits can be easily quantified and winners and losers identified, and developed a method for arranging such rules on a linear scale susceptible to standard statistical analysis. In the third of a century since Wilson first posited his hypothesis, no one else has managed to do this.

Her results provide empirical support for the intuitions many of us have about taxes—most importantly, federal income and payroll taxes. The largest earmarked federal tax—the payroll tax—has been subject to remarkably little tinkering; Tahk’s work suggests that earmarking may explain its durability. Tax expenditures, by contrast, produce concentrated benefits and diffuse costs. Again, her work supports the public choice explanation for their proliferation and persistence.

Much remains to be done. Most importantly, Tahk’s scoring is subjective. Diffusion and concentration are not rigorously defined. Why are education benefits—which affect large numbers of voters—“concentrated,” while business profits—which may actually affect fewer voters—“diffuse”? I can tell a public choice story that supports Tahk’s characterization, but it is more complex than her paper acknowledges. One suspects that replication would produce similar results, but a more tightly defined scoring algorithm would make follow-up studies more compelling.

In the general scheme of things, however, this is a nit. Tahk’s paper is profoundly innovative and deserves a read.

Cite as: Theodore P. Seto, An Empirical Test of Public Choice Theory, JOTWELL (August 5, 2014) (reviewing Susannah Camic Tahk, Public Choice Theory & Earmarked Taxes, N.Y.U. Tax L. Rev. (forthcoming, 2015), available at SSRN), http://tax.jotwell.com/an-empirical-test-of-public-choice-theory/.