Yearly Archives: 2016

U.S. Tax Policy and Puerto Rico’s Fiscal History

Jul 5, 2016 Shu-Yi OeiAdd a Comment

Puerto Rico faces a host of public finance woes. It owes over $70 billion in public sector debt. On May 2, 2016, it missed a major debt payment to its Government Development Bank bondholders. Congress is currently considering legislation that will allow Puerto Rico to restructure its debts. Without debt restructuring, further defaults seem inevitable. Puerto Rico has attempted to use its tax laws to ease its public finance problems. However, in March, the United States District Court for the District of Puerto Rico ruled in Wal-Mart Puerto Rico v. Zaragoza-Gomez that an increased tax imposed by Puerto Rico on certain cross-border, related-party property transactions violated the U.S. Constitution and the Federal Relations Act. The court acknowledged that the tax was implemented to quickly raise revenue to ameliorate Puerto Rico’s fiscal challenges, but it struck down the tax nonetheless. As of this writing, Puerto Rico’s fiscal future remains uncertain.

Puerto Rico’s economic and fiscal condition and its tax policy are, of course, related, and the United States has played an important role in both. But what exactly is the United States’ economic relationship with Puerto Rico? What do U.S. tax and fiscal policies with respect to Puerto Rico tell us about that relationship? And how have these policies influenced the economic trajectory of the island? Tax aficionados may be broadly familiar with tax incentives for investment in Puerto Rico, but what deeper story lies beneath?

Diane Lourdes Dick takes up these questions in her article entitled U.S. Tax Imperialism in Puerto Rico. The article develops a theory of U.S. tax imperialism, which I understand to be a subset of economic imperialism, by detailing the ways in which U.S. tax policy has been used to control the economic trajectory of the territory for the benefit of the mainland.

Professor Dick describes three historical stages of such tax imperialism:

In the first stage, beginning after the Spanish-American War of 1898 and continuing through 1919, the United States revamped Puerto Rico’s tax laws, which had developed under Spanish rule. In essence, U.S. interventions during this period decreased reliance on indirect taxes (for example, by replacing older consumption-type excise taxes with more narrowly defined excises) and increased Puerto Rico’s reliance on direct taxes on personal and corporate income. An existing tax on income from property was also replaced with one based on property valuations. Professor Dick discusses the impact of this property tax in pressuring Puerto Rican landowners to either sell or productively utilize their property; the effects of the tax on land ownership; and the tax’s role in the formation of a single-crop sugar economy, which benefitted large U.S. sugar corporations.

In the second stage, spanning 1920 through 1974, Professor Dick characterizes the United States as pursuing tax and economic policies designed to utilize Puerto Rico as a low-cost provider of manufacturing inputs for U.S. corporations, thereby reducing dependence on foreign sources for these inputs. For example, a federal tax exemption for the foreign-source income of certain U.S. corporations that derived income from U.S. possessions was enacted. This exemption was converted into the Section 936 possessions tax credit by the Tax Reform Act of 1976. When paired with changes in Puerto Rico’s tax laws exempting U.S. corporations from Puerto Rico’s income, property, and other taxes, this exemption effectively provided U.S. companies with a blanket tax holiday in Puerto Rico.

In the third stage, from 1975 to the present, by contrast, concerns about capital flight from the United States mainland to Puerto Rico and other locations led to a shift in U.S. tax policies, with a new emphasis on incentivizing capital to flow out of Puerto Rico and back to the U.S. mainland. Professor Dick notes that the U.S. now allowed U.S. parent corporations to claim a full dividend-received deduction for income earned in U.S possessions. However, Puerto Rico’s counter-move—extension of Puerto Rico’s withholding tax to repatriated dividends—worked to offset the incentive to repatriate earnings to the U.S. mainland. U.S. legislators eventually responded by repealing the Section 936 possessions tax credit in 1996 (subject to a ten-year phaseout), with complete elimination for tax years beginning after December 31, 2005. But the repeal led many corporations operating in Puerto Rico to convert their subsidiaries to controlled foreign corporations, effectively keeping capital offshore and preventing the U.S. Treasury from taxing it, thus thwarting the U.S. goal of encouraging repatriation of earnings back to the United States.

In setting out a three-stage theory of tax imperialism and by situating U.S. tax and fiscal policy against the broader backdrop of U.S. economic policy in Puerto Rico, U.S. Tax Imperialism in Puerto Rico challenges the dominant narrative surrounding U.S.-Puerto Rico economic relations and Puerto Rico’s current fiscal condition. This narrative tends to portray the U.S. as a benevolent patron and to blame Puerto Rico for its continuing fiscal difficulties. Professor Dick’s article illuminates the tax and economic imperialism underlying the evolution of U.S. tax policy with respect to Puerto Rico, presenting a wide-ranging analytical history of the economic relationship between the U.S. and its territory and discussing how U.S. tax policies have contributed to Puerto Rico’s current fiscal problems. As I read it, the main takeaway is not so much that any one policy is necessarily bad in and of itself, but that as a matter of motivation, the U.S. has been using Puerto Rico for its economic advantage for over a hundred years and has designed Puerto Rico’s tax policies to U.S. ends.

U.S. Tax Imperialism in Puerto Rico is a careful, interesting, and timely account of how the U.S. has designed tax policies with respect to Puerto Rico since 1898, but its contribution does not end there. The article also raises broader questions. For example, one wonders whether similar dynamics have been in play with respect to the other U.S. territories. Another important question concerns Puerto Rico’s relatively unnoticed place in the history of capital flight from the United States. According to Professor Dick’s account, capital flew from the U.S. to Puerto Rico as a result of tax incentives. But then it fled further and more permanently abroad due to the increasing use of controlled foreign corporations by U.S. corporations. The growth in controlled foreign corporations occurred in response to the repeal of the possessions tax credit and the broader shift in U.S. tax policy in Puerto Rico after 1975. This account potentially muddies the usual story about capital lockout and capital flight: it suggests that contrary to the usual narrative, offshoring of U.S. capital cannot be entirely attributed to direct comparisons between the U.S. and other sovereign competitors. Rather, at least some capital may have moved from the U.S. to U.S. possessions such as Puerto Rico, and then to more distant shores as a result of U.S. tax policy with respect to the possessions. This is a topic that merits further investigation.

Don’t Delegate This Reading

Jun 15, 2016 Kim BrooksAdd a Comment

In modern regulatory states, the theoretically firm lines dividing the legislative, executive, and judicial branches of government are increasingly blurred. Teasing out how to design and enforce effective regulation has become a major preoccupation of scholars and policymakers in every area of law.

Delegating Tax, an article by the talented James R. Hines Jr. and Kyle D. Logue, is wonderful reading in that light. The article contrasts the reluctance of Congress to delegate the lawmaking authority of the IRS and Treasury in the tax area with Congress’ increasing willingness to delegate that authority to other federal administrative agencies. The authors make the case for great delegation in the tax area, noting the potential for the executive branch to draw on greater expertise and to respond more quickly.

Hines and Logue create a taxonomy of delegations that they urge Congress to consider: delegation of parameters for tax subsidies to the Treasury Department, delegation to set some income tax rates to an independent agency like the Federal Reserve, and delegation of tax reform to an independent commission. Hines and Logue would reserve the ability for Congress to fix the distribution of tax liabilities to ensure “fair distribution.”

I enjoyed reading the whole article, although my favourite part was the authors’ efforts to answer the question, “Why should the regulatory approach to tax policy differ from regulatory approaches to other areas of federal policy?” (P. 259). They examine historical accident and path dependence and the value of retaining the ability to set rates with Congress as a key tool in facilitating bargaining in the legislative process. They find each possible justification to be wanting.

The piece concludes with an exploration of the constitutional constraints on expanded tax delegation. Ultimately, the authors conclude that their proposed delegations should “pass constitutional muster” (P. 271).

The article takes on the broad areas where more delegation might appropriately be considered as a mechanism for accessing some of the benefits of the executive branch. The authors acknowledge at the outset of their piece that Congress could replace the Internal Revenue Code with a single sentence, “The Department of Treasury shall promulgate all tax rules necessary to raise revenue sufficient to balance the federal budget and shall do so in a manner that is fair and efficient” (P. 238), although they do not recommend that approach. The Hines and Logue article provides the platform from which readers can ask additional questions about delegation among the branches of government in the drafting of every provision in the Internal Revenue Code (or any piece of legislation, for that matter).

The question of the appropriate balance among the legislative, executive, and judicial branches in tax lawmaking is not unique, of course, to the United States, although the balance struck in the United States has unique features. Hines and Logue’s article contributes to the conversation highlighted in comparative work on this same topic advanced by Chris Evans, Judith Freedman, and Richard Krever in The Delicate Balance: Tax, Discretion, and the Rule of Law (IBFD, 2011). It’s a pleasure to see that the dialogue continues.

Putting a Face to International Tax Avoidance

May 20, 2016 Andrew HayashiAdd a Comment

The world of international tax avoidance is a colorful one. There are the legal structures, with names like the “Double Irish Dutch Sandwich,” the exotic locales, like Bermuda and the Cayman Islands, and the identity crises presented by “hybrid” entities and financial instruments. But rarely does international tax avoidance have a human face and one could be forgiven for getting the impression that falling effective corporate tax rates are as inevitable as water flowing downhill. Corporations, acting in the interests of their shareholders, maximize their after-tax profits. States, acting in the best interests of their residents, set tax policies that are incongruous with the policies of other states. The “bad actors,” if there are any in this story, are corporate aggregates of one sort or another, multinational corporations and tax haven countries.

But the LuxLeaks scandal has given us one human face that stands out from the crowd of aggregates. This is the face of Marius Kohl or “Monsieur Ruling,” the former head of the Luxembourg agency, who gave rulings to taxpayers on the tax treatments of their proposed transactions. In The State Administration of International Tax Avoidance, Omri Marian does a wonderful job of explaining how this one bureaucrat acted to facilitate massive tax avoidance by engaging in “arbitrage manufacturing.” Marian argues that rogue individuals pose an ongoing threat to international tax cooperation. His paper clearly explains how arbitrage can be manufactured, documents how it was done in Luxembourg, and draws from the LuxLeaks episode an important lesson about the need to integrate micro reforms of tax administration into the macro project of international tax harmonization efforts.

This emphasis on individual actors, including not only Kohl but also the relatively small number of accountants and tax advisors working in on behalf of US and UK clients in Luxembourg, is one of the significant contributions of the paper. States and their regulatory agencies do not make decisions, individuals do. Those individual decisions are the results of their own private calculi, and shifting attention to individual incentives and constraints is an important analytical step. We cannot assume that tax administrators’ preferences necessarily align with best interests of their own country. Shifting attention to the incentives and constraints of the decision-makers themselves will force us to confront the monitoring, supervision, and optimal incentive structure problems for tax administrators that we do in other settings. The problem with Kohl was, in some sense, another example of regulatory capture, but one that has received little attention in the international tax compliance context where, as Marian notes, the focus has been on the harmonization of substantive tax laws.

Marian grounds his argument in an original data set. By thoroughly reviewing 172 tax rulings, Marian is able to provide a broad account of Kohl’s ruling practices as tax administrator. He reports descriptive statistics about the kinds of taxpayers who sought rulings, the time that was spent reviewing the applications, the legal issues on which rulings were sought, and the names of the tax advisors who submitted the rulings. Marian is generally persuasive in arguing that it is implausible that Kohl could have given the applications more than a cursory review, given the time that he spent with them; however, he cannot completely rule out the possibility that the ruling applications merely reflected agreements negotiated in advance between Kohl and the taxpayers. But this is a minor point in light of all of the other evidence Marian presents to suggest that Kohl was fully pliant. Although Marian does not compare the merits of the positions taken in the ruling applications with the particulars of Luxembourg law, the indirect case he makes for Kohl rubber-stamping the applications is compelling. Most damning is that Kohl afforded the same financial instrument different treatment in order to comply with different taxpayer requests.

Marian has done a service by compiling a dataset from these rulings, but in addition to the effort involved in hand-coding this new dataset, there is much to admire about the restraint and care that he demonstrates interpreting it. He is forthright about the limitations about what can be generalized about tax administration from this one episode, and fastidious about noting potential issues. When evaluating any empirical study, the reader must be able to assume that the author has done the analysis with integrity and has carefully considered and set forth the key assumptions of the approach. This paper gives every indication that Marian is a trustworthy guide.

The OECD’s project on base erosion and profit shifting includes a proposal that would address the particular debt/equity arbitrage that was most common among the transactions approved by Messr. Ruling. This proposal would require matching, so that a payment that was not includible in income in the payee country could not be deductible in the payor country. This is a good rule. But Professor Marian’s point, ably illustrated by the case of Marius Kohl, is that it is insufficient to harmonize substantive tax laws. Certainly this needs to be done, and harmonization must cover as many countries as possible. But in the final analysis it will be individuals who make enforcement decisions and rule on ambiguous cases.

In this realm, like so many others, we need to think about how to police the police. Doing this effectively requires understanding what motivates bureaucrats and regulators but, unfortunately, investigations into the LuxLeaks scandal have provided few answers to this question. Neither Marian nor the journalists who have covered the story have been able to explain why Kohl acted as he did. Was he compensated? Did he relish the power to give people what they wanted? Was he merely indifferent to the performance of his duties? Marian provides a valuable contribution in drawing attention to the powers of individual actors. Further work should focus on what motivates those actors, so policymakers can design the proper incentives and monitoring regimes to regulate them.

It’s Time To Revisit The Tax Treatment of Working Childcare Costs

Apr 20, 2016 Kathleen DeLaney ThomasAdd a Comment

Childcare costs have soared in recent years while wages remain stagnant. To make matters worse, relief by provided by the tax code is extremely limited. Parents may be able to claim a tax credit for a portion of their childcare costs and may be able to divert limited funds to a pretax flexible spending account. But in many cases, these tax benefits capture only a minor portion of parents’ costs. It is no surprise, then, that with an election year upon us, a number of proposals to expand the current childcare tax credit have resurfaced in recent months. These proposals echo years of debate over whether the tax system discourages work by secondary earners and treats working parents unfairly vis-à-vis their non-parent counterparts.

But current proposals to modestly expand the childcare credit will make only a small dent in working parents’ childcare costs. Recognizing the inadequacy of such an approach, Shannon Weeks McCormack proposes a more fundamental reform in her forthcoming article, Over-Taxing the Working Family: Uncle Sam and the Childcare Squeeze. The childcare tax credit, she argues, should be replaced with an above-the-line deduction for childcare expenses that is not subject to phase-outs or dollar limitations. In essence, Weeks McCormack calls for according childcare expenses the same treatment as deductible trade or business expenses.

The debate over whether childcare expenses represent personal consumption or the cost of earning income has been well documented by scholars. On the one hand, having children generally represents a personal choice and childcare expenses are not incurred by all workers. On the other hand, childcare expenses are often a “but for” cost of earning income, much like deductible business expenses. This debate began, however, in a time when secondary wages (generally earned by women) were often discretionary. In years past, a mother who “chose” to work and hire a caretaker for her children was, arguably, making an elective decision. What Weeks McCormack’s article adds to this debate is a fresh and much-needed modern perspective.

As Weeks McCormack states, “Today, most two-parent families consist of two earners and require at least two incomes to meet their needs. The pressure to find work is even greater for single parents. . . .” Indeed, the reality today is that many (if not most) parents purchase childcare services because they must work outside the home to make ends meet. And, Weeks McCormack notes, childcare options are often limited. Daycares may have waitlists and working parents may purchase more expensive in-home childcare services because they cannot afford to take off of work if their child gets sick. These facts not only cut against the presumption that childcare costs are elective, but they also undermine the presumption that parents pay caregivers only the perceived consumption value of their services. When viewed in this light, childcare expenses look less like personal consumption today than they might have fifty years ago. To be sure, some taxpayers still receive significant consumptive benefits from childcare arrangements and would perhaps incur those expenses independent of the decision to work, a fact that Weeks McCormack acknowledges. However, because this group likely makes up a small and decreasing segment of working parents, policies that assume this potential consumptive benefit do not make sense. In other words, child care expenses in today’s world are a necessary cost of earning income for most parents, which makes them more akin to deductible business expenses.

Weeks McCormack also has an insightful take on why expanding section 21’s childcare tax credit is an unsatisfactory solution. Not only are tax credits prone to phase-outs, caps, and other limitations, but credits are often considered to be tax expenditures. This is relevant because under the Haig-Simons definition of income, deductions that represent the cost of earning income (e.g., business expenses) must be taken into account to calculate net income and therefore are not considered to be tax expenditures. If childcare expenses are also considered to be a cost of earning income, a deduction or credit for these expenses should not be considered a tax expenditure either.

Interestingly, the original version of section 21 was a (somewhat limited) tax deduction for childcare costs, which Congress converted to a credit in 1976 in order to eliminate the upside-down subsidy effect of deductions. But, Weeks McCormack notes, the legislative history to that amendment specifically described childcare expenses as a cost of earning income, and Congress accordingly rejected the notion of an income-based phase-out of the credit. However, that message was lost over time, as the credit subsequently has been pared down and subjected to both income phase-outs and dollar limits. The Joint Committee on Taxation also included the working childcare tax provisions on its list of tax expenditures, which contradicts the notion that childcare expenses are a cost of earning income.

The result, Weeks McCormack observes, is likely confusion on the part of lawmakers, who view the working childcare tax provisions as legislative “giveaways” rather than a means of properly measuring income. When considered in this light, it’s not surprising that the current regime provides insubstantial support for many working parents. Thus, Weeks McCormack argues, meaningful tax reform requires not just expanding the scope of tax relief for working parents, but reframing that relief in a manner that reflects its purpose, i.e., removing it from the list of tax expenditures and converting it to a deduction that is necessary to accurately measure net income.

Weeks McCormack also offers some interesting practical suggestions for implementing her proposal. One possibility is to enact a deduction that looks something like section 274(n)’s 50 percent limitation on the deductibility of business meals. While Weeks McCormack thinks 50 percent deductibility is too low, I think this approach could offer an attractive political compromise that would still put many working parents ahead of the current regime. And while I don’t believe that a deduction would realistically encourage parents to go out and incur lavish childcare expenses, Weeks McCormack argues that such concerns could be assuaged by enacting limitations on lavish and extravagant expenses similar to those imposed on business entertainment and meal expenses.

As working parents continue to struggle financially, Weeks McCormack’s article is vitally important and timely. Politicians and other policymakers would be well-advised to pay attention.

Widening the Critical Tax Lens

Mar 23, 2016 Bridget J. CrawfordAdd a Comment

The road to same-sex marriage was paved with a tax decision. In United States v. Windsor, 133 S. Ct. 2675 (2013), the United States Supreme Court recognized that same-sex spouses, like different-sex spouses, have the right to pass assets to each other tax-free at death. In arriving at that decision, the Court invalidated the portion of the Defense of Marriage Act that provided that the word “marriage,” for federal purposes, meant only a legal union between a man and a woman. With Windsor, a same-sex marriage that was valid for purposes of state law would be recognized for purposes of federal law. In a tax sense, Windsor put same-sex couples and different-sex couples on equal footing for federal purposes. Many commentators accurately predicted that the Windsor case laid the foundation for the Court’s recognition two years later of a constitutional right to same-sex marriage in Obergefell v. Hodges, 135 S. Ct. 2584 (2015).

In the wake of the Windsor and Obergefell decisions, some tax scholars have drawn important attention to legal issues created in the period between Windsor and Obergefell for same-sex couples whose states did not recognize their marriages, as well as challenges faced by those who choose civil unions over marriage. Other tax scholars are wary of Obergefell’s glorification of marriage as the highest form of human fulfillment, and are skeptical that marriage is the correct foundation for a variety of procedural and substantive rules.

Enter into this conversation Lily Kahng’s thoughtful examination at how women in same-sex couples might fare from a tax perspective in a post-Windsor, post-Obergefell world. For almost twenty years, Kahng has been a leading and consistent voice in critiquing the fiction of marital unity in the tax law. In The Not-So-Merry Wives of Windsor: The Taxation of Women in Same-Sex Marriages, Kahng turns on its head the assumption that same-sex marriage is a salutary shift in the legal landscape for same-sex couples. Kahng argues that under federal law, women in same-sex couples will be taxed unfavorably compared to women in different-sex couples.

Kahng builds her argument through studied examination of three areas of tax law: the joint income tax return, the estate and gift tax marital deduction, and the earned income tax credit. By showing how these laws impact hypothetical female same-sex couples, Kahng exposes the tax law’s improper channeling of benefits based on marital status. Through specific numerical illustrations involving hypothetical two-earner and single-earner couples, Kahng shows in a practical way how the marriage penalty and marriage bonus operate. She illustrates how middle-income couples and high-income couples are the most likely to receive a marriage bonus, and how two-earner upper income couples are the most likely to experience a marriage penalty. (For anyone who has ever struggled to understand precisely how the “marriage bonus” or “marriage penalty” operate, Kahng’s elegant numerical illustrations will quell any confusion.) Kahng then takes the important step of using census data regarding labor force participation of women in same-sex couples to show that they are more likely than women in different-sex couples to experience a marriage penalty and they are less likely to receive a marriage bonus. This is because women in same-sex couples tend to have both partners engaged in market labor and more equal incomes than different-sex couples. Although the reasons for these earning patterns are beyond the scope of Kahng’s article, the next step might be to understand why same-sex female couples are more likely than different-sex couples to have two working spouses, and why that income is more likely to be more equal. One suspects it has to do as much (or more) to do with the fact that women earn less for market labor than their male counterparts than any personal preference or traits unique to women in same-sex relationships.

Building on her understanding of earning patterns, Kahng turns to the QTIP trust, gift splitting and estate tax portability to ask what couples are likely be benefit from wealth transfer tax laws that accord preferences to married couples. Kahng’s examples illustrate that all three of these techniques—QTIP trusts, gift splitting and portability—are applicable only to taxpayers who have wealth in excess of the wealth transfer tax exemption amount, or $5.43 million in 2015 ($5.45 million in 2016). And within that group of wealthy taxpayers, the control that QTIP trusts in particular afford will be especially appealing mostly to those who have less-wealthy spouses. Although Kahng acknowledges limitations in the data regarding the wealth of women in same-sex marriages, the spouses’ relatively equal levels of labor force participation and income levels suggest that their wealth levels also are likely to be equal or close to equal as well, which means that they will be less likely than different-sex couples to benefit from gift and estate tax marital preferences. To the extent that women in same-sex couples might want to take advantage of QTIP trusts and the ability to direct the disposition of trust property upon the death of the surviving spouse, it may be to protect children from prior relationships.

Kahng uses census data to convey the stark reality that female same-sex couples are more likely than different-sex couples to be living in or near poverty and the spouses are more likely to have relatively equal incomes. The reasons for this are not well understood, but Kahng explains the tax context. Again through numerical illustrations, Kahng shows that a low-income unmarried couple comprised of two individuals with relatively equal earnings will receive a greater earned income tax credit than a similarly-situated married couple. That EITC marriage penalty might discourage some taxpayers—in both same-sex and different-sex couples—from marrying. To the extent that they are more likely than people in different-sex couples to have relatively equal earnings, women in same-sex couples will be more likely to either incur a marriage penalty or be deterred from marriage in greater numbers than women in different-sex couples.

For anyone interested in understanding the tax implications of the Supreme Court’s recognition of same-sex marriage, Kahng’s article is a must-read. Writing squarely within the critical tax tradition, Kahng looks at the tax system to ask important questions about advantage and disadvantage. For years, critical tax theorists have taken up the challenge of identifying ways in which the tax system privileged different-sex couples over same-sex couples. With this article, Kahng widens the critical tax lens further, inviting readers to consider the ways that women in same-sex couples might experience the tax law differently than men in same-sex couples or men and women in different-sex couples. The quest for fairness in taxation must be a nuanced one, as Lily Kahng’s careful work demonstrates.