The recent work of David Weisbach and Daniel Hemel, including the Legal Envelope Theorem, engages with traditional questions about tax systems in important new ways. Legal tax scholarship has long explored the interactions between tax law and taxpayer behavior and has often used intuitions from economics in doing so. But only haphazardly has this work touched on the effects of nontax institutions on the functioning of tax systems. The Legal Envelope Theorem looks at these interactions in very deliberate ways.
At the risk of oversimplifying, Weisbach and Hemel’s thesis is that changes in non-tax legal rules and institutions that at first might appear to be undesirable can be desirable when their effects on tax systems are taken into account. More precisely, a nontax change that makes almost no change in overall well-being can make a significant after-tax increase in overall well-being if the non-tax change increases taxable income, increases collection of taxes, or increases potential for redistribution.
For instance, imagine a nontax rule change that increases the likelihood that an individual will participate in a market transaction that produces taxable income rather than in a nonmarket or otherwise untaxed activity. It is entirely possible that the overall benefit to society created by the additional taxable income will be greater than the small detriment to the individual whose behavior is affected.
More specifically, to use the article’s first example, assume an individual can choose to use land to raise cattle for sale for $10, or to raise vegetables for home consumption for a benefit of $7. The income from raising cattle is taxed at 30%; the consumption of vegetables is not taxed. Assume further that there is a change in the non-tax rules, perhaps a tightening of the limitations on fertilizer use that will increase the value of the drinking water on the land but raise the cost of producing vegetables. This rule change causes the individual to use more land for taxable cattle raising and less for nontaxable vegetable growing, producing $10 of additional taxable income but at a loss of $7 worth of vegetable production. We can infer from this choice that the after-tax benefit to the individual of $7 ($10 in income less $3 in tax) from cattle production is slightly better than the after-tax benefit to her of remaining in vegetable production given the increase in the cost of vegetable production (reduced by the fertilizer limit to slightly below $7). But there is now an additional $3 in tax revenue. This tax revenue represents a resource available to society; in particular, revenue that can be used for redistribution.
Thus a rule change can reduce inequality not only by directly redistributing as a result of the application of the rule, but by enhancing the government’s ability to collect revenues that can then be used for redistribution. In focusing on the creation of revenue for redistribution, Weisbach and Hemel position their work as a continuation of the long running debate about the appropriateness of shaping substantive legal rules with an end toward reduction of inequality. The conclusions of economists, most notably Louis Kaplow and Steven Shavell in several works (the most recent of which is Should Legal Rules Favor the Poor?, 29 J. Legal Stud. 821 (2000)), soundly reject this idea. They argue instead that the most efficient results can be achieved if legal rules are set independently of distributional concerns, with any resulting inequality addressed through taxation. Weisbach and Hemel counter that legal rules should also minimize the efficiency costs of redistribution through the tax system. They raise the possibility that legal rule changes that enhance the effectiveness of tax systems can be desirable even if they deviate from simple efficiency before tax collection is taken into account.
Two aspects of the above discussion may seem unintuitive, but should not affect a reader’s understanding. if she is forewarned. The first is the assumption that the collection of $1 of tax revenue does not effectively destroy that value. In the article’s terms, “the value of $1 in the hands of the individual and the government is the same,” p. 457. All too many economic analyses seem to assume that the mere collection of tax destroys the full value of the amount collected.
An additional way in which the reader’s intuitions may result in confusion is the unfortunate use of the cattle/vegetable tradeoff in the first example in the article—unfortunate simply because the current understanding of the impact of cattle raising on the environment and human well-being more generally suggests that any change that increases cattle production would not be beneficial. The example seems to have been chosen to help readers already familiar with similar examples in the economic literature.
The article does introduce other examples of interactions that will seem more intuitive to the reader: any rules that discourage the use of cash for nontax purposes are likely to have a positive effect on revenue collection simply as the result of a reduction in gray market transactions; any rules that encourage the creation of business records, including the Statute of Frauds, are likely to make auditing for tax collection purposes more effective; rules that impose standard terms on corporate charters are likely to improve tracing the values the corporation creates to its owners for tax purposes; mandated benefits in the employment context can result in an increase in the return to marketplace labor and thus to taxable product; rules that improve records of property ownership can permit more effective tax collection. (This last was previously identified by James C. Scott in Seeing Like a State (1998) although Scott viewed this as likely producing a reduction in well-being as a result of enhanced state tyranny.)
Weisbach and Hemel have made a significant contribution merely by identifying these interactions between non-tax rules and tax systems. Their additional analysis in this article shows that these interactions can produce desirable results, and that changes in legal rules should be made (and may in the past have been made) deliberately to enhance the operation of tax systems, since such changes can involve a trade-off between a small non-tax cost and a large increase in tax revenue as a result of indirect enhancements in the operation of the tax system. There is a lot more to do for those interested in working through the theoretical economic insights on which this analysis rests, including the relationship between the Legal Envelope Theorem and the more general Envelope Theorem of microeconomics. Some of this work is also outlined in greater detail in other papers, including The Behaviorial Elasticity of Tax Revenue, 13 J. Legal Analysis 381 (2021) and, with Jennifer Nou, Appendix to “The Marginal Revenue Rule in Cost-Benefit Analysis.”, available at SSRN (Aug. 13, 2018).
