Yearly Archives: 2014

The IRS as Tax Law Nonenforcer

Dec 17, 2014 Leigh OsofskyAdd a Comment

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.

Keeping Us Honest about the Timing Flaws in the Income Tax

Nov 19, 2014 Charlotte CraneAdd a Comment

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.

Evaluating the Efficacy of Nonmonetary Tax Penalties

Oct 21, 2014 Kristin HickmanAdd a Comment

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.

Next Up, Incest

Sep 17, 2014 Lily Kahng1 comment

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.

An Empirical Test of Public Choice Theory

Aug 5, 2014 Theodore P. SetoAdd a Comment

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.