The Virginia Tax Review always includes something that I end up chewing on for far longer than I expect to, and the most recent number to cross my desk (Spring 2009) is no exception. It includes a piece entitled The Recovery of Unlawful Taxes by Jacob Nussim of the Bar-Ilan Law faculty in Israel. The piece is an English language version of work that apparently has appeared in Hebrew, and a technical version of the piece has been available on SSRN for a while now. But the food for my thoughts is all in the readily accessible VTLR version.
Issues relating to refunds of illegal taxes have reemerged recently, at least in the federal system. First came the government’s defeat in the International Court of Trade in the Harbor Maintenance Tax litigation in the 1990’s, and then came continuing litigation despite the government’s recent concessions regarding the Telephone Excise Tax. Neither case involved major threats to the fisc, but both involve potentially significant changes in the procedural rules that historically have discouraged taxpayers from pursuing claims that federal taxes were unlawfully collected. If Congress is forced in the coming years to invent new tax instruments, the ground rules for handing challenges to these new tax instruments will become increasingly important.
A word of warning is probably appropriate here: although I am fairly sure that I do not agree with many of the premises of the article (since I think that the burden should be on taxpayers to challenge potentially unlawful taxes both politically and early on in the courts, before nonstatutory judicial remedies must be invented), and I am not sure that I fully understand the part that is Nussim’s original contribution (since there is a little bit of unexplicated legerdemain in the layman’s version of the mathematics). What appeals to me is the effort that he has put into situating his micro-economic analysis in the real world in which it might be applied.
Nussim’s principal claim is that our instincts about the “passing on” defense, at least as applied to claims for refunds of unpaid taxes, are simply wrong. Under this defense, a taxpayer is not entitled to a refund of taxes that should not have been paid (whether because they were illegal or because they were simply paid by mistake) unless the taxpayer can show that it bore the economic burden of the tax. The commonly articulated justification for this defense is that the taxpayer should not recover taxes for which it was reimbursed by its customers, because such payment would amount to a windfall. Nussim’s insight is that this analysis fails to take into account the fact that the taxpayer will rarely have actually passed on the full amount of the tax because the taxpayer will have taken into account the fact that it might turn out to be illegal. Even if there are no other market constraints on the taxpayer’s ability to pass the burden of the tax on, it will only try to pass on the expected burden of the tax, taking into account the possibility that the tax will be refunded.
In laying out his conclusions (p. 929), Nussim points out that the use of passing on defense itself amounts to a tax increase above and beyond the nominal tax that can be legally collected under the tax instrument in question. On the one hand, this is obvious, and has always been, since the whole point of the passing on defense is that the government gets to keep the taxes that it should not have collected in the first place. This is, as Nussim admits, pretty obvious. (He, perhaps a bit unfairly, accuses courts and legislatures of failing to appreciate this. More on that below.) But how bad is it if such expropriative schemes are allowed? An amount of taxes greater than was authorized by law was collected, and governments constrained by law should not be permitted to engage in such expropriative schemes. That is not a particularly original point, and applies to any defense against refunds of unlawful taxes, not just the passing on defense. Nussim’s original contribution ultimately is that the actual relative burdens involved in imposing this possibly unlawful tax, should it prove to have been unlawful, will depend upon whether taxpayers viewed their potential refund as limited by the passing on defense.
In the VTLR version of his thesis, Nussim has taken great pains to provide the reader with a full view of the legal sources of the passing on defense. That in and of itself would distinguish it from many other works using microeconomic approaches to analyze tax instruments and thus merit my praise, even if he does leave the reader with the impression that as a matter of positive law the passing on defense is far more commonly invoked than it actually is. But my greatest praise is for the fact that he clearly sees that one cannot assess the burden of a tax simply by looking at what the law on the books says. The procedural aspects of collection and the refund process—and not just the structure of the audit lottery or ways of calculating winning on the merits—are important factors that must be taken into account in determining what the tax instrument put in play by the legislature actually is.
Nussim does stop a bit short. To me, the passing on defense is best seen as a substantive hurdle embraced by judges and legislators who are relieved to be able to provide a plausible reason for refusing to refund taxes. The next step should be to provide them with something coherent to replace it.