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Hardship Withdrawals from 401(k)s: A Trap for the Unwary

Sep 9, 2024 Emily SatterthwaiteAdd a Comment

Those who are committed to strengthening safety nets for economically precarious workers at modest revenue cost should look no further than Goldburn Maynard and Clint Wallace’s paper on hardship-related early withdrawals by employees from their 401(k)/403(b) qualified retirement plans. Employees who need to make an early withdrawal due to hardship are, by definition, encountering difficulties and have lower ability to pay. Nonetheless, as Maynard and Wallace describe, a subset of hardship distributees may be surprised by a mismatch in the law that can heap further hardship upon them in the form of penalties.

The mismatch occurs between two sets of rules: first, the “hardship distribution” rules addressed to qualified plans under Code subsection 401(k), which allow a plan administrator to permit withdrawals before the employee reaches retirement age and, second, the rules addressed to taxpayers under Code subsection 72(t), which apply a 10 percent “early withdrawal” penalty. The regulations under 401(k) list various safe harbored-payments that constitute an allowable hardship distribution in response to “immediate and heavy financial need” that cannot be satisfied using other resources. (Pp. 3-4.) These payments include those for medical care that would be deductible under Code subsection 213(d), costs related to the purchase of a home for the employee, tuition expenses for post-secondary education, as well as payments to prevent eviction or foreclosure, for funeral expenses, and for a natural disaster or casualty loss. (Pp. 3-4, 26.) However, those same safe harbored-payments are not fully mirrored in the subsection 72(t) penalty framework, which contains a divergent list that doesn’t include eviction and foreclosure, limits qualifying medical care expenses, and allows payment for post-secondary educational expenses only in the case of individual retirement account holders, not those who have 401(k)/403(b) qualified plans. (Pp. 30-31.) As a result, some hardship distributees fall between the cracks: “[d]espite qualifying for the hardship distribution safe harbor, [they can avail themselves of] no exception to this separate penalty…” (P. 4.)

This mismatch might seem like a minor issue likely to affect few employees, but those who are affected constitute a group that has revealed itself to be struggling to make ends meet. Maynard and Wallace cite 2019 IRS and GAO studies documenting that, among the 1.7 million who received about $17 billion in hardship distributions, there is a higher likelihood of having total retirement assets of $5,000 or less, being low-income or somewhat low-income, being African American or Hispanic (i.e., not “White, Asian or Other”), being less-educated, having a larger family, and being widowed, divorced or separated. (Pp. 23-24.) Of this group, a whopping 1.2 million paid the 10 percent penalty (P. 23); those who are penalized are “poorer and nonwhite taxpayers who have the smallest account balances.” (P. 6.) For those ensnared by the mismatch, the penalty is almost guaranteed to exacerbate financial precarity. As Maynard and Wallace write, “the taxpayers who fall into the gap between hardship distribution rules and early withdrawal penalties constitute the most vulnerable account holders.” (P. 25.)

One of the aspects of the paper that makes it so engaging is its profile of a mother of three called Tiffany (all names in the paper were changed to protect privacy), who was assisted by the Low Income Taxpayer Clinic at South Carolina Law (round of applause to Clint and each LITC law school!). Tiffany needed funds because she “had fallen behind on her housing payments and was facing eviction; the withdrawal was necessary to keep her and her three young children from becoming homeless.” (P. 3.) Luckily, Tiffany’s plan permitted hardship distributions (bafflingly, plan administrators are not required to offer them). (P. 27.) Tiffany was permitted to make an early withdrawal from her employer’s 401(k) plan in accordance with the hardship distribution rules that contain the eviction safe harbor. But she wasn’t told that the same rules didn’t apply to the 10 percent penalty, or that eviction payments were not covered. Thus, Tiffany found out at tax time that she was responsible for a 10 percent penalty on her early withdrawal.

Maynard and Wallace point out that the application of the 10 percent penalty in cases like Tiffany’s fails to advance the dual policy goals identified in the penalty provision’s legislative history. (Pp. 4-5.) First, the penalty is supposed to function as a commitment device to prevent employees from shortsightedly draining their retirement savings. (P. 37.) However, it could not work as a deterrent in this regard for Tiffany: she gained knowledge of the penalty only after taking the action that triggered it, and was operating under the impression that she was not subject to the penalty because of her hardship situation. Second, the penalty is designed to recapture tax benefits that employees had reaped from having their savings grow tax-free in the qualified plan. (Pp. 4-5.) But because a low-income employee like Tiffany would likely be subject to the statutory zero percent rate on long-term capital gains, the penalty put Tiffany in a worse position than if she had forgone the use of her 401(k) entirely (Maynard and Wallace walk through an enlightening numerical example specific to low-bracket taxpayers). (Pp. 24-25.) The only thing it accomplished was raising a small amount of revenue from someone who could ill-afford to pay and understandably might feel misled by the mismatch.

Maynard and Wallace make a strong case that the IRS and Treasury, without any action by Congress, should improve communication, including using better vocabulary, about these two closely-related sets of rules. (Pp. 10-11, 39-40.) They argue that the use of clearer language would help employees understand that receiving approval for a hardship withdrawal is insufficient for waiving the penalty. On the legislative front, they propose a detailed set of reforms, two of which I’ll highlight. First, they recommend adopting a default income tax withholding obligation for plan administrators to avoid saddling employees with surprise tax bills. Second, they propose harmonizing the hardship withdrawal and penalty rules so that the same criteria that permit a plan administrator to make a hardship distribution could waive the early withdrawal penalty. (P. 36.) They point out that this has been accomplished to some extent by SECURE Act 2.0’s adoption of a $1,000 penalty-free hardship withdrawal provision (see recently-released Notice here), but Maynard and Wallace take issue with the meagre permitted amount.

As a supplement to this for the most vulnerable employees, they propose a resource-based waiver of the early withdrawal penalty in the case of a hardship distribution; their preferred approach is to offer a penalty waiver to those with lower total retirement assets. Here, the tricky part is defining what that means and addressing the discontinuity in treatment implied by a bright-line threshold. Moreover, they acknowledge that “this [resource-based waiver] approach might curtail the commitment device effect of the penalty for some.” (P. 37.) In not advocating for the abolition of the penalty in the case of all hardship withdrawals, the authors seem to endorse the commitment function of the penalty, even in the case of hardship, for better-resourced employees. However, they argue, eliminating the hardship withdrawal penalty for under-resourced employees may augment the propensity of this population to use the qualified plan vehicle for retirement savings “by giving some employees comfort that they can make contributions without later suffering consequences of depositing funds in an account [that is] out of reach in case of emergency.” (P. 37.) This is ultimately an empirical question and it would be fascinating to test this via an experiment or other study.

The article concludes by linking the maladies of the qualified plan hardship distribution regime with the larger themes of complexity, uncertainty, and unworkability in U.S. retirement saving policy for those with lower incomes. As the authors point out: “401(k) plans have been designed with an expectation that individuals can make and stick with long-term commitments, consider the time value of money, evaluate different investment options, and shoulder the burden of significant uncertainty about their investment decisions and their future preferences—all dubious expectations in the real world.” (P. 19.) Few will come away from this work unconvinced that low-income employees, and particularly those who are experiencing hardship, are poorly-served by the status quo retirement savings system.

Is There Finally a New World (Economic) Order?

Jul 30, 2024 Adam RosenzweigAdd a Comment

In 1944 forty-four nations signed an agreement in Bretton Woods, New Hampshire, which laid the foundation for what would become the modern international economic system. The so-called Bretton Woods system was built on the commitments to free and open trade, stable monetary exchange markets, and investments in global public goods. One of the motivating factors underlying the Bretton Woods agreement was to prevent the kind of trade protectionism, isolationism, and hyperinflation that had been seen as some of the geopolitical factors ultimately leading to World War II. While the Bretton Woods agreement itself only lasted until 1971, the commitment to liberalized trade, liquid currency markets, and investments in global public goods continued and came to be known collectively as the “Washington Consensus.”

In recent years, however, cracks have begun to emerge in the Washington Consensus under the stress of the Financial Crisis, the COVID pandemic, and increased protectionism and trade wars. At the same time, the Organization for Economic Cooperation and Development (OECD) began the single most significant overhaul of the global tax regime since its inception through its Base Erosion and Profit Shifting (BEPS) project. Over one hundred and forty countries eventually reached near universal agreement on fifteen separate Action Items fundamentally overhauling the international tax regime. This success stands in stark contrast to the otherwise perceived crumbling of the Washington Consensus. Was this merely another notable example of tax exceptionalism? Or could the success of BEPS serve as a model for revitalizing the Washington Consensus?

Professor Rebecca M. Kysar intervenes in this debate in her new article, The Global Tax Deal and the New International Economic Governance. The underlying premise of the article provides that the success of the BEPS negotiations proves the demise of the Washington Consensus, not its survival.

On its face this might come across as a surprising, if not controversial, claim. After all, despite their faults the World Bank, IMF, etc. remain the backbone of the modern international economy and the US dollar remains the world’s reserve currency, etc. Yet the article convincingly proclaims the end of the Washington Consensus by situating the question within the context of broader global macroeconomic and geopolitical trends, in particular a clearly emerging commitment throughout the global community to a more equitable distribution of the benefits of any new global economic order. To this end, Kysar defines a number of features of this new order as contrasted with the Washington Consensus, briefly summarized as follows: (1) replacing the unwavering commitment to open markets and free trade with a general distrust of markets and stronger preference for state regulation, (2) expanding beyond trade and economic liberalization to incorporate global distributional considerations as a core policy goal, and (3) relaxing the commitment to one-size-fits-all global institutions to allow for more regional cooperation and adoption of non-reciprocal duties and benefits.

Ultimately the most powerful impact of the article even by its own terms doesn’t lie in the persuasive power of any of its details but rather in its broader claim that such details are growing almost anachronistic because the global community has already moved past the fundamental tradeoff between efficiency and equity underlying the Washington Consensus. More specifically, to date (for the most part) equitable considerations have routinely lost to efficiency considerations whether framed as open markets, free trade, capital neutrality, or other forms. As a result, calls for equitable proposals have not only failed to gain traction in the face of this “thumb on the scale” for efficiency but worse too often have been dismissed as “payoffs” to “bad” actors precisely because they depart from the efficiency baseline of the Washington Consensus. For this reason, the core thesis of the article that equitable and distributional considerations can no longer be considered departures from the consensus efficiency baseline but rather co-equal components of that baseline proves far more radical than may appear to many at first glance. Without fear of hyperbole, perhaps no other scholar could be better suited to undertake such a profound paradigm shift. Not only is Professor Kysar a widely published and influential expert in the field, but as noted in the article she co-led global tax negotiations for the United States from 2020 through 2021. From this combined perspective, the article does not merely serve as a form of oral history, on the one hand, or a purely theoretical model, on the other, but rather a combination of the best of both worlds—to powerful effect.

Of course, this does not mean there are no details or specifics over which reasonable people could disagree. In particular, some might not buy the contention that the emergence of the Washington Consensus strongly parallels the themes emerging out of the BEPS negotiations. After all, the Bretton-Woods conference explicitly centered on the creation of a wholly new post-War economic system while the BEPS negotiations by their own terms were meant to shore up that same system. Of course, the US Constitutional Convention was similarly convened only to amend the Articles of Confederation yet there can be little doubt an entirely new structure of government was embodied in the Constitution that emerged at its conclusion. It is possible others may doubt the extent of similarity between the international tax system and the international trade system, especially given the pervasiveness of so-called “tax exceptionalism” within those systems themselves which has kept the two mostly distinct since their post-War emergence. Even the best of articles will include details that some could criticize or specific examples that could be nitpicked. But the article by its own terms recognizes this and attempts to avoid getting caught up in the quicksand of these debates by keeping its focus on the unique perspective of what has actually worked in the real world over the past decade. For this reason, perhaps the best compliment I can give to Kysar’s article is that it may not be the piece of scholarship any one of us may have wanted, but it assuredly is the piece of scholarship we all need.

Capital Gains and Race: Through A Different Lens

Jul 3, 2024 Dorothy BrownAdd a Comment

Professor Richard Winchester’s Essay, A Simple Tax Case Complicated by Race, is a very enlightening and quick read. His Essay details a Tax Court decision about whether a sale of land by a real estate developer is eligible for favorable tax treatment. And while most law students who have taken a single individual income tax class would rightly tell us the answer is no, Professor Winchester takes us through an opinion that finds otherwise—because of race! First, a primer for my non-tax-geek readers.

For most of our modern income tax history, the gain applicable to the sale of capital assets like stock or real estate held by investors, has been eligible for a low, preferential tax rate. Sales of inventory, or property “primarily for sale to customers” on the other hand are taxed at the highest ordinary income tax rates available. Real estate developers therefore are selling property they hold for sale to customers and generally ineligible for the lower, preferential tax rate. Except, Tax Court Judge Withey did not get the memo. Why? Professor Winchester argues that it is because of race.

The decision, Pontchartrain Park Homes, Inc. v. CIR, holds that the gain from the sale of real estate by a developer is eligible for the lower preferential tax rate—because the developer was doing something extra risky: building a subdivision of homes for sale to prospective black homebuyers during Jim Crow.

The story of how the development came to be is alone a valuable contribution to the literature. In 1950, a white Baton-Rouge based builder, Hamilton Crawford, along with the white mayor of New Orleans, deLesseps Story Morrison (the name alone deserves its own movie), agreed to build two communities: one white (Gentilly Woods) and one black (Pontchartrain Park) separated by a ditch. (Plessy v. Ferguson allowing “separate but equal” was still good law.) The purpose of Pontchartrain Park was to ease the housing shortage faced by black Americans and potentially prevent protests. (P. 38.) Financing for both were provided by the Federal Housing Administration (FHA). During this time FHA insurance generally flowed to developments that excluded black Americans. In this case an exception was made because of pressure applied by Mayor deLesseps Story Morrison on the FHA.

In 1951, Hamilton Crawford and a business partner bought the land. (P. 40.) By 1954, he teamed up with two New Orleans philanthropists to build Pontchartrain Park through a new company aptly called Pontchartrain Park Homes, Inc. (PPHI). Within a year, PPHI purchased the land from Crawford and his business partner, and construction soon started. By 1957, PPHI had completed installing improvements on about half the land, but it still had 188 unsold homesites. It took a pause and accepted an unsolicited offer from the state to buy seventeen acres of undeveloped land to build a satellite campus of Southern University, a Historically Black College and University. PPHI turned a profit of $154,019 on the sale and the issue was whether that profit was subject to the lower, preferential tax rate that applies to capital gains. The taxpayer claimed the lower preferential tax rate on their tax return and the Internal Revenue Service (IRS) disagreed. Tax court Judge Withey found for the taxpayer as did the Fifth Circuit on appeal albeit with a different analysis.

The Tax Court according to Professor Winchester (and any law student who took the introductory course) “incorrectly observ[ed] that raw land is generally a capital asset in the hands of a real estate developer.” (P. 41.) Professor Winchester notes that Judge Withey’s language describing how PPHI served “a market, the potentialities of which were a virtually unknown and untested factor in its experience or that of its incorporators,” meant in Winchester’s words that PPHI’s “customer base of Black buyers made it unique.” (P. 41.)

Because the development was for black homebuyers—something unheard of in the Jim Crow South—PPHI was not like the ordinary real estate developer who had a history of selling real estate to these customers. Their customer base was white. The market for white homebuyers was well established. Not so for the black homebuying market. Judge Withey concluded that any raw land was an investment when acquired by PPHI, making it a capital asset from the beginning. (P. 42.)

As Professor Winchester points out though, the facts do not support that conclusion. PPHI’s charter looked like “that of any other real estate developer.” (P. 42.) And “the company always classified its undeveloped land as ‘inventory’ in its books.” (P. 42.) The IRS naturally appealed and a three-judge panel of the U. S. Court of Appeals for the Fifth Circuit issued a per curiam opinion rejecting the Tax Court’s theory that the land was not primarily held for sale to customers when the company acquired it, but because PPHI’s purpose was changed substantially after acquisition, the Fifth Circuit concluded that it “was no longer held primarily for sale to customers” by the time the actual unsolicited offer to sell was received. The appellate court expressly rejected the Tax Court’s analysis that the land was an investment from the very beginning. (P. 43.)

Professor Winchester notes the role that race played in the Tax Court opinion. He argues that race made Tax Court Judge Withey interpret the law against precedent and in favor of the white developer’s company that was developing homes for sale to black Americans. Professor Winchester in effect describes the “market risk” discussed in the opinion as a dog whistle for race and notes how the Judge’s assumptions about black homeowners were the ultimate driving factor in his opinion. I might add that the Judge may have also seen PPHI as a sympathetic taxpayer, trying “to do the right thing” and therefore deserving of the capital gain tax break—a tax break that recent Treasury Department research shows is disproportionately received by white Americans.¹

Professor Winchester points to current research that shows a tendency for Americans to associate “homeownership with whiteness.” (P. 44.) (Perhaps Judge Withey associated eligibility for the low, preferential rate with whiteness as well.) Professor Winchester discusses research that the FHA’s bias against insuring homes owned by black Americans is replicated in today’s market even though that bias has long been made illegal under the 1968 Fair Housing Act. “[H]omes located in racially integrated areas receiv[e] substantially lower bank appraisals than the ones for comparable homes in all-white areas.” (P. 44.) As Professor Winchester points out, that has real substantive economic impact.

In case you think this case is old and cold, Professor Winchester notes how Judge Withey’s decision was cited in a 2018 IRS brief, where the government argued the sale by PPHI was of raw land treated as a capital asset because “the company was in the business of selling improved lots, as opposed to raw land.” Of course, as he notes, this comports with the Tax Court opinion but not the Fifth Circuit’s decision. As Professor Winchester observes, “Withey’s rationale in PPHI’s case has retained some persuasive power, despite the Fifth Circuit’s admonition.” (P. 46.)

Professor Winchester urges all judges to be aware of and sensitive to any implicit racial bias that might cloud their thinking. Otherwise, there may be more simple cases…“complicated by race.” (P. 47.)

An Original Take on the Original Meaning of the Sixteenth Amendment

Jun 7, 2024 Jon ChoiAdd a Comment

The Sixteenth Amendment is one of the most thoroughly studied texts in U.S. federal tax law—economists, historians, and luminaries of constitutional law and taxation have all sliced and diced its meaning for more than a century. Making an original discovery about the historical meaning of the Amendment has consequently taken on the dimensions of a mythic quest, like discovering an Eleventh Commandment or the secret dryer compartment containing all those lost socks.

Remarkably, this is exactly what John R. Brooks and David Gamage accomplish in their timely forthcoming article, The Original Meaning of the Sixteenth Amendment. Brooks and Gamage marshal a wide variety of evidence, including new historical evidence on the technical meaning of “income,” to argue that the income taxable without apportionment under the Sixteenth Amendment includes unrealized gains. This has huge implications for policy, given that many current and proposed taxes are imposed on unrealized gains, including some of the most important recommendations to tax the very rich. Brooks and Gamage’s work is especially timely given that the Supreme Court will rule on Moore v. United States in the next month or so, possibly deciding the constitutionality of taxes on unrealized capital gains—although Brooks and Gamage’s contribution goes far beyond the current case, especially if it is decided on narrow grounds.

Brooks and Gamage’s article is remarkably thorough in its examination of the historical context and public meaning of the Sixteenth Amendment at the time of its ratification. They make two main contributions. First is a purposivist analysis of the meaning of the Sixteenth Amendment, arguing that it was understood as a specific measure to overrule Pollock v. Farmers’ Loan and Trust Co. and should be interpreted as such. Second, the authors present extensive contemporary textual evidence on the meaning of the term “income,” including evidence so far neglected in constitutional debates.

The article’s exposition of the purpose of the Sixteenth Amendment is thorough and compelling, although presumably less so to textualists (obviously an important interpretive bloc on the current Supreme Court). But the real coup de maître comes in the second contribution. Most significantly, the authors unearth new historical evidence showing that varieties of income taxation in effect at the time the Sixteenth Amendment was ratified included elements of “mark-to-market” taxation of unrealized gains. For example, they show that the federal Corporate Excise Tax of 1909 required including the appreciation in value of unsold property in income if it was recorded on a corporation’s books. They also show that accounting standards in place at the time of the Sixteenth Amendment included unrealized gains in income. Taken together, the evidence suggests that the contemporary technical meaning of “income” in the context of taxation did include unrealized gains.

Brooks and Gamage take a sophisticated interpretive position here, and they acknowledge doubters on the other side. Perhaps most prominently, a team of corpus linguists who have analyzed contemporary language usage at the time of the Sixteenth Amendment’s passage conclude that “income” was commonly understood to require realization. Brooks and Gamage have some points of disagreement with the corpus linguistic analysis. Moreover, they argue that it is beside the point—that the ordinary meaning of “income” is not relevant when we have good evidence of the technical meaning of “income,” which as used in the Sixteenth Amendment is a tax law term of art.

Constitutional and textual interpretation are subtle, and cases sufficiently ambiguous to make their way to the Supreme Court do not admit of easy answers. Slam dunk arguments on these matters are therefore almost impossible, and there are grounds on which reasonable interpreters could disagree. But Brooks and Gamage’s article is as persuasive and original as I have seen on these issues, and makes interpretive contributions that will resonate for decades to come.

Opportunity and Obstacle: State Tax Incentives and the Fight Against Poverty

Apr 19, 2024 Adam ThimmeschAdd a Comment

The stark contrast between the United States’ widespread prosperity and the deep-seated poverty afflicting many of its people and communities underscores the nation’s complex economic landscape. Equally complex are the political and legal landscapes surrounding our nation’s anti-poverty efforts. States currently have much of the responsibility for administering federal anti-poverty programming and for directly serving the people and places suffering from economic hardship. Simultaneously, however, states are restricted in their abilities to pursue social welfare goals because of the mobility of capital and labor within the United States. States have responded to these challenges by turning to investment-based tax credits to drive development, but that approach has been disfavored by many progressives and often fails to deliver help to the in-state people and places in need.

Michelle D. Layser offers a unique assessment of this difficult situation in her recent article, Removing Barriers to State Tax Incentive Reform. In that piece, Layser weaves together her knowledge of the political economy of community development, place-based tax incentives, and the federal constitutional restrictions under which states operate to argue that tax incentives likely remain the best path forward states under current conditions. However, states will need help to overcome some key barriers, including the dormant Commerce Clause, to ensure the success of those programs.

Layser and others have previously explored the many problems that exist with the federal government’s place-based tax credit programs, and there is no shortage of criticism for provisions like the Opportunity Zone Tax Credit that was implemented as part of the 2017 Tax Cuts and Jobs Act. Those programs tend to increase investments in the targeted locations, but often without helping the current residents in those areas. Against this backdrop, we might expect that Layser would promote an entirely different approach for the states, but she identifies a critical factor suggesting caution in abandoning place-based tax incentives at the state and local level—the political economy of community economic development. Her article is thus unique and refreshing in that it does not just dwell in the negative aspects of the current system. Instead, she offers a new way to think about reform from within the current construct.

Layser does not just concede the field to those focused on economic growth. Instead, she makes the case that place-based incentives, properly tailored, can serve efficiency ends while also resulting in social welfare gains. Here, she draws from economic research and from her own prior work to help to sway progressive reformers to think more openly about place-based incentives. She is of course careful to note that only reformed incentives are likely to bring long-term success on social-welfare metrics.

From that point in the article, Layser shifts to a detailed analysis of two major aspects of state-level reform. She first analyzes the strengths and weaknesses of three different types of state-level place-based incentives—state enterprise zone laws, state opportunity zone laws, and state new markets tax credit laws. Her critical insight in this analysis is that states’ programs often are either not limited to, or do not actually result in, investments that benefit in-state places or people. Instead, state tax credits can be obtained for investments that benefit workers from outside a targeted place or even for investments made in other states. That extraterritorial flow of state funds likely undermines a state’s goal of helping those most in need within its own borders—a critical flaw.

Layser next identifies the types of reforms that might make those incentives better suited to promoting social welfare within a state’s borders. She breaks those reforms into two categories, minor and major, and evaluates each with the goals of better serving low-income residents and of serving local distressed places. Her next point is critical and one of the key insights of her article. She recognizes that, although states would best serve their own interests by limiting their tax incentives to investments specifically directed at in-state persons or places, the Supreme Court’s dormant Commerce Clause doctrine prohibits tax incentives that discriminate in that way. And while that doctrine allows for direct spending of that kind, states face significant obstacles to making those types of appropriations. Ultimately, then, the dormant Commerce Clause stands as a significant barrier to the types of reforms that Layser identifies, and state tax-incentive programs suffer as a consequence. (It is worth noting that the article is comprehensive in that Layser also analyzes the potential limitations of the Privileges and Immunities Clause and the Equal Protection Clause, but the dormant Commerce Clause is the real impediment to the reforms that she suggests.)

So, what do we do about these issues? Layser concludes by providing suggestions for overcoming the legal and political impediments to reform. On the law, she rightfully notes that Congress can override the Supreme Court’s dormant Commerce Clause doctrine and allow states to discriminate against interstate commerce. Congress could thus allow states to tailor their programs to in-state residents or in-state places and thereby help states to better fulfill their anti-poverty responsibilities within their borders. States can also take advantage of the disconnect in the Supreme Court’s doctrine between discriminatory taxes and discriminatory cash subsidies. If the political process allows for direct spending—a far from assured thing—this route might help states to target their incentives more appropriately. Layser also addresses the politics of these proposals at the state and federal level and provides ways to engage with politicians at both levels.

Despite the “War on Poverty” being waged in America since the 1960s, deeply impoverished people and places continue to exist throughout the country. Layser’s article provides an important explanation of how state-level approaches are being undermined by the political economy of community economic development, by poorly designed state incentives, and by federal law that prevents states from doing better. Her article is a must read for anyone interested in helping to improve place-based tax incentives and our overall national approach to addressing poverty in America.

Going Formal: The Tax Lives of Nannies

Mar 8, 2024 Susan Morse1 comment

Workers who provide child care in children’ homes—that is, nannies—should almost always be “formal” workers based on existing law. But in fact they are almost always treated as “informal” workers paid off the books and not as employees. Formality would mean more work law protection – that is, from labor, employment, and social insurance law. But it would also mean more income and payroll taxes.

Is going formal worth it?

In Taxing Nannies, Ariel Jurow Kleiman, Shayak Sarkar, and Emily Satterthwaite consider this question from an obvious yet original perspective. They focus on the preferences and welfare of nannies, not hirers. Their empirical work shows that some nannies strongly prefer formality. It also suggests that the market assumes informality and quotes compensation on an after-tax basis. A tax incidence negotiation between nannies and hirers results over how to split the tax burden of going formal, and diverse solutions follow.

The authors analyzed data from the online platform Reddit, using a strategy similar to that used by Shu-Yi Oei and Diane Ring to investigate the tax lives of rideshare drivers. Kleiman, Sarkar, and Satterthwaite examined about three hundred posts from the “r/nanny” subreddit. They found that 81% of the 150 or so posts that consider worker classification express a preference for formal employee status, for reasons including legal compliance and needing documentation. The documentation preference connected to both public benefits reasons, for instance unemployment insurance or Section 8 housing vouchers; and private market reasons, for example apartment or mortgage loan applications. The authors found a similar result when they survey 57 predominantly female, white, documented, and highly paid nannies. Seventy-five percent of their survey respondents preferred formal employee treatment, and most of these offered legal or tax compliance—not, for example, dignity or professionalism—to explain their preference.

Kleiman, Sarkar, and Satterthwaite also interviewed 15 experts, including from payroll service providers, nanny membership groups, and workers’ rights organizations. (P. 54.) Some interviewees characterized the nanny work sector as a “cash industry” (P. 56.) with a strong default norm of informality. But others observed a sea change toward formality, especially because of the collateral benefits of documentation for public benefit and private market purposes. The experts also cited hirer-side motivations such as reputational concerns.

Kleiman, Sarkar, and Satterthwaite are careful not to generalize their finding of a preference for formal work among some nannies.  They acknowledge that lower-wage nannies might have different preferences, and that undocumented workers in particular might prefer informal status. (P. 38.) But they write that their work invalidates “the null hypothesis that nannies as a whole prefer informality over formality.” (P. 9.)

If some nannies prefer formal work, then who will pay for the taxes that are the price of formality? Some of the most interesting posts uncovered by the paper reveal the negotiation over the tax incidence of going formal. Nannies’ wages historically have been quoted after tax—a practice that “diverges from nearly all employment sectors” (P. 46.) since employee wages are almost always quoted on a gross basis, before income tax or employee-side payroll tax. Thus, going formal raises an unusual incidence question: How to split the burden of a voluntary agreement to pay more in tax.

The paper suggests that nannies often focus on the practice of quoting post-tax wages, which implies that hirers should bear the tax burden, while hirers sometimes focus on the practice of quoting pre-tax wages in the rest of the employment market, which implies that nannies should bear most of the tax burden. For instance, one Reddit post endorsed by 232 upvotes compared a nanny’s belief that her hirer was “responsible for taxes as an employer” to the hirer’s statement that “I don’t know if we can afford to pay you $25 and pay your taxes.” (P. 46.) When nannies and hirers negotiate over such disagreements, a diversity of agreements results.

For instance, some hirers agree to “gross up” nannies’ pay, by paying in cash the amount of tax withheld. (P. 46.) (The gross-up cash is, of course, also taxable compensation income that should be reported.) Other hirers may offer some compensation on the books and some off the books; cash payments might be made for overtime, for instance, or, in some carefully negotiated cases, for amounts that would cause compensation to exceed benefit cliff limits for programs such as Section 8 housing vouchers or Medicaid. Other hirers may consider a nanny to be an independent contractor subject to tax reporting requirements but may allow the nanny to believe that their arrangement is off the books; later, when the hirer presents the nanny with a 1099, it is often an unpleasant surprise.

The evidence presented by the paper shows that some nannies prefer formal arrangements, and that these preferences may also assume that hirers will bear the resulting tax burden. But the paper also presents evidence of nanny-hirer negotiations, which shows that going formal often requires nannies, as well as hirers, to bear some of the burden of the increase in tax. The work law protections may come at a price, counter to the assumptions of at least some proponents of greater enforcement and formality.

The authors make three policy suggestions intended to ease this tension. First, they propose to save on transaction costs by simplifying compliance. Second, they endorse immigration reform, including a special path to work status for caregivers. Increasing the proportion of documented nannies should encourage more unified support of the move toward formal work and perhaps improve the bargaining position of nannies in general. Third, they suggest expanded public benefit systems, including specific benefits for caregivers, to mitigate the effect of benefits cliffs that encourage some off-the-books compensation for nannies.

The last idea of expanded public benefits specifically targets the problem of going formal. It injects value into the hirer-worker negotiation to offset the value lost to the burden of paying tax in a formal arrangement. The authors do not detail a social reproduction theory or other justification for singling out the child care labor market for extra government support. But regardless of any theoretical takeaway, this paper’s fascinating empirical analysis is highly recommended. It reveals key details about this important corner of the labor market, and about that market’s ongoing struggle with the benefits, costs, and tax incidence of going formal.