Tax Policy Exam

"Ability to Pay" Principle

"Ability to pay": Taxation according to capacity to bear tax, e.g., progressive tax rates based on annual income (current approach) ◦Realization vs mark-to-market taxation of capital income? Contrast: "Benefit principle": Vary tax burden according to benefits received? Example: Gas tax which funds highway infrastructure Compare other "ability-to-pay" measures: Tax burden based on -- ◦lifetime income ? ◦consumption* ?

excess profits taxes

"Excess Profits" Taxes were instituted during war times to recover windfall profits accruing to certain industries whose products were in demand because of the conflict. During COVID-19, certain industries have seen windfall profits while others have suffered.

payroll taxes

(FICA, FUTA) pay for: -Social Security -Medicare -Unemployment Insurance

sources of state and local tax revenues

(most to least) property tax individual income tax general sales tax select sales taxes corporation income tax

World War 2

- 1939: New Deal ends, but FDR remains President. Mobilization for WWII begins. -FDR proposes to tax all "excess income" to fund the war, as a wartime sacrifice -Strong opposition: Fear of post-war depression. Instead, conservatives advocate a national sales tax replace income tax. But FDR fiercely opposes, and proposal fails -Pearl Harbor 1941. War in Europe and now also in the Pacific - 1942-45: Compromise - no national general sales tax. Instead -- -Income taxation became more broadly applied, to middle class - Income taxation became more progressive: Top individual tax rate over 90% and top corporate tax rate of 90% on "excess profits" -Payroll tax withholding extended beyond Social Security: "Collection at source"

the modern tax income

- Before 1913, high tariffs, plus excise taxes on alcohol and tobacco, were the principal source of federal government revenues •Meanwhile States continued to rely on property taxes. By 1911, property taxes accounted for nearly 60% of all revenues combined of the three levels of government (federal, state & local) -The income tax was expected to provide just a supplement to the tax revenues above - and a tool for economic justice. Not expected to ultimately become the predominant source of federal revenue -Because of high exemptions, only about 2% of the highest income US households paid the 1913 income tax. Tax rates were 1%-7% -Top tax rates raised during WWI, but very narrowly targeted: By 1918, the top 1% paid 80% of the income tax, and only the top 15% paid any income tax at all -Taxing "excess profits" of corporations - e.g., 60% tax on rates of return over 33% -- with prohibition of pass-through of this tax to consumers and workers -This new tax alone paid for 2/3 of the American cost of World War I -Republicans take over in 1918, after WWI and -- -Repeal excess profits tax -Reduce tax rates on wealthy (top rate 73% → 25%) and on corporations -Introduce preferential rate on capital gains (half the ordinary income rate) -Themes: "Ability-to-pay"/Progressivity VS Economic growth/ "Trickle down"

Are Government Budget Deficits/Debt Bad?

- Crowding out private sector capital: -Deficits must be funded by borrowing - US Treasury sells bonds to investors -Public bonds compete with private bonds for investor capital → interest rates rise -And if deficits are instead funded by printing money: Inflation risk -Crowding out other government spending: -As national debt increases, more interest must be paid on government bonds -Interest expense (especially if interest rates rise) then displaces discretionary government spending on education, infrastructure, etc -But deficits may be appropriate as economic stimulus during economy down cycles. (And more recently, modern monetary theory (MMT) has suggested deficits are OK when interest rates and inflation are low, and excess spending is on infrastructure.) -Republicans in recent decades have suggested high deficits act as a justifiable restraint on growth of big government - reigning in excessive government spending

sources of complexity

- complicated economy -> complicated rules - use of the tax system to promote social and economic policies - frequent changes in law-by all three branches of the federal government -interaction with the laws of non-US countries and the States - drafting choices. e.g., multiple definitions of the sa,e term; cross-references

How Can Governments Provide Certainty?

-Advance rulings & real time audits -International standards and coordination; tax treaties -Speedy and impartial dispute resolution -Statutes of limitations, which provide finality -Safe harbors and bright line tests -Legislative changes that are infrequent, occur in a transparent process allowing for comments, and offer transition relief - ◦One constraint: Tying the legislature's hands. E.g., 3/5 vote to raise taxes; budget rules

tax advisor skills

-Advocate effectively for tax rule changes on behalf of your clients (lobbying) -Anticipate and thus position your clients/employer for likely changes (planning) -Navigate within ethical guardrails so as to protect the reputation of your clients/employer - and yourself (acting as counselor) -Intelligently predict what rules are highly likely to exist, even if you may not yet have found the statutory language (advising + research)

sources of federal revenue timeline

-Declining contribution from corporate income tax and excises -Growing contribution from payroll taxes -Nearly 85% of Federal revenues come from individual taxes (individual income tax plus payroll taxes)

Adverse Effects of Complexity

-Excessive costs of compliance -Tax incentives go under-utilized, undercutting intended purpose -Reduced perception of fairness -Decreased levels of voluntary compliance

Externalities - Education Tax Incentives

-Exclusion for employer-provided educational assistance. IRC 127 -Deduction for educational expenses that maintain or improve skills in taxpayer's current occupation. IRC 162 -Deduction for higher education expenses (tuition and fees) -Tax credits: American Opportunity; Hope; Lifetime Learning -Tax favored savings accounts for education. IRC 529 -Student loans: (1) Deduction for certain interest, and (2) Exclusion for certain debt cancellations -Tax-exempt status for educational institutions

Presidential Privacy Rights? Supreme Court Asked to Decide on Trump Tax Returns

-In Trump v. Vance Jr., New York prosecutor sought the president's financial records to determine whether he falsified business records by listing hush money paid to Stephanie Clifford and Karen McDougal as legal expenses -September 2020: New York Times reveals it obtained 20 years of leaked Trump tax returns through 2018, which reveal he paid little or no federal taxes in most of those years -Feb 22, 2021: US Supreme Court rules against Trump. Mazars released records to Vance. Public disclosure not expected due to grand jury secrecy rules -In Trump v. Mazars USA and Trump v. Deutsche Bank, the Court was asked to rule after Congressional committees asked for Trump's financial records -Dec 2021: Federal district court declines to prevent release of tax returns. Trump files immediate appeal

what can be taxed?

-Income (e.g., wages, capital gains, dividends, interest, royalties, rents, & more) -Consumption (e.g., retail sales taxes, Value Added Taxes) -Purchases of selected goods (e.g., gas tax, tobacco & alcohol "sin" taxes, excise taxes) -Wealth/Assets (e.g., estate and inheritance taxes, college endowment tax) -Property (e.g., real estate taxes, business assets, auto taxes) -Cross Border Trade (e.g., customs duties/ tariffs) -Gross receipts (e.g., new "digital services taxes" in Europe and elsewhere) -Transactions (e.g., real estate transfer taxes, gift taxes, stamp taxes)

the new republic (early history)

-Independence declared (1776), but new Continental Congress lacked authority to tax -Power to tax was reserved to the States, so States had to finance the Revolution -In 1788, the US Constitution was ratified - finally giving Congress the right to tax (and to borrow and have the exclusive right to print currency): Article I, Section 8: Congress shall have the power "to lay and collect taxes, duties imposts, and excises." -But with a constraint: No right to impose certain "direct" taxes: Article I, Section 9: "No capitation, or other direct tax shall be laid, unless in proportion to the census." -Federal government relied mostly on low import duties until the Civil War, -- made possible by economic expansion driving ever increasing trade, and vast public lands -States funded most major public programs and projects, through property taxes

largest source of tax revenue

-Individual income taxes (53%) -Social insurance taxes (Social Security, Medicare, Unemployment) (32%) -Corporate income taxes (7%) -Estate and gift taxes (2%) -Excise taxes (2%) -Customs duties (2%)

composition of federal spending

-Interest rates have remained low for an extended time, reducing the relative burden on the federal budget -Social insurance programs have been expanded, such as the addition of Medicare in 1965 and the Medicare prescription drug program in 2003 -Demographics - the over-65 cohort (retirees) has grown as a percentage of population, increasing costs

biggest category of federal government spending

-Mandatory Spending (62%) - Social Security, Medicare, Medicaid, Welfare, Veterans Benefits -- collectively called "entitlements" because spending is automatic, i.e., no annual appropriation by Congress -Discretionary Spending (30%) - Congress must appropriate funds annually. Includes defense spending (50%), highways, foreign aid (& the IRS budget) -Interest (8%) - To finance the budget deficit, the US government must borrow by selling US Treasury bonds, and each year pay interest to the buyers

Externalities - Innovation Tax Incentives

-Non-tax laws also seek to offset this market failure, e.g., patents which provide temporary monopoly; direct government/military funding of R&D -Research & Experimentation tax credit. IRC 41 -Incremental tax credit, designed to reward only increases in R&E spending -Design flaws: -Income tax credit useless to a start-up running losses - so benefit accrues mostly to large corporations -Source of significant complexity and disputes: What is "innovative"? How do you separate expenses for R&E from other expenses? [2017 IRS Directive: Can use ASC 730 expenses] -Probably rewards R&E spending that would have occurred without tax incentive -Made permanent in 2015, but previously was temporary provision extended 20+ times since 1981 ! ØR&E expenses fully deductible in year incurred, even though income-producing benefit from R&E spending is spread over years. IRC 174 ◦ Compare purchase of a machine - capitalization of expense and recovery over years o But now after TCJA: In 2022, new rule will apply - spread over 5 years -Inventor incentive: Capital gain treatment for sale of patent, even if paid as royalty. IRC 1235 -Do other countries have better ideas? -R&D "superdeduction", e.g., 150% deduction for R&D expenses (e.g., UK) -Patent boxes - IP income taxed at significantly lower tax rate than normal tax rate ◦ Offered in 16 countries, with rates averaging 10% (vs 26% average corporate tax rate) ◦ US tax bill (Boustany-Neal) introduced in 2015 would have offered 10% US rate (not law) ◦ TCJA: New US deduction for income derived from licensing US patents abroad (13% rate)

Externalities - Environment/Energy Taxes

-Tax policy seeking to offset negative externalities -- -Excise tax on ozone-depleting chemicals (CFCs) -Gasoline tax (18 cents per gallon federal excise tax) -Proposals: Carbon tax, Btu tax -Tax policy seeking to produce positive externalities -- -Tax credits or favorable cost recovery treatment for investments in renewable energy production (e.g., wind, geothermal, biomass) or facilitating pollution-control -Tax credits for residential investments in energy-efficient equipment. IRC 25C, 45L -Tax credits for alternative fuel vehicles -Tax-exempt treatment for bonds issued to fund energy and conservation projects

between the world wars

-The Great Depression (1929-1933). Unemployment rose to 25% in 1933 (and damage lingered for years, with unemployment still at 15% in 1940 !) -Herbert Hoover (R) president. At first, he accepted deficits as economic stimulus, but then decided deficits should be reduced. Top income tax rate was raised from 25% to 63% -Depression worse, Franklin D. Roosevelt (D) is elected President in 1932 - The "New Deal" -FDR aided by repeal of Prohibition: Alcohol tax revenues returned. Along with tobacco and new gas taxes, excise taxes accounted for 40% of Federal revenues in 1936 -1935: FDR introduces Social Security -- and payroll taxes to pay for it. Structured as an insurance program, with current workers paying for current retirees -1936: FDR taxes corporate retained earnings, & capital gains at 39% -- and cuts spending -Recession of 1936-37 follows. Political sentiment shifts - but FDR tax reforms survive

evaluating a tax system

1. Does it interfere with economic efficiency? 2. Is it fair? 3. Is it simple and easily complied with? 4. Is it administrable and enforceable? 5. Can taxpayers plan with certainty?

typical pathway for a tax bill to become law

1. House & senate action (Tax bill introduced and considered by House Ways & Means Committee->sent to house for vote-> if passed, sent to senate and referred to Senate Finance Committee; SFC alter House version of bill-> SFC version of bill sent to Senate Floor for vote) if passed, 2. Conference Committee, Floor Votes, Presidential Approval or Veto (bill goes to Joint Conference Committee->bill goes to house and senate for vote-> bill passed, sent to president-> president signs bill into law OR president vetoes bill and it goes back to congress where congress must pass bill with two-thirds majority to overrule President's veto

top 10 individual tax expenditures over 10 year period

1. exclusion of employer contributions for medical insurance premiums and medical care 2. exclusion of net imputed rental income 3. capital gains (except agriculture, timber, iron, ore, and coal) 4. defined contribution employer plans 5. defined benefit employer plans 6. child credit 7. step-up basis of capital gains at death 8. deductibility of mortgage interest in owner-occupied homes 9. capital gains exclusion on home sales 10. deductibility of charitable contributions, other than education and health

top 10 corporate tax expenditures

1. reduced rate on active income of controlled foreign corporations 2. credit for increasing research activities 3. accelerated depreciation of machinery and equipment 4. deduction for foreign-derived intangible income derived from trade or business within the United States 5. credit for low-income housing investments 6. tax credit for orphan drug research 7. energy production credit 8. exemption of credit union income 9. energy investment credit 10. special ESOP rules

How should governments tax?

1.Ability to pay (all ought "contribute...in proportion to their respective abilities") 2.Certainty and simplicity ("certain, and not arbitrary... clear and plain to the contributor and to every other person.") 3.Administrable (collect tax when taxpayer "is most likely to have wherewithal to pay.") 4.Economic efficiency a.Minimize costs of tax collection (tax collector "salaries", taxpayer "vexation") b.Minimize distortions that "discourage ... business that might give employment to multitudes" -- by excess tax burden or by "forfeitures and other penalties"

World War II and After - From "Class" Taxation to "Mass" Taxation

>Highly progressive income tax rate structure o Top individual income tax rate: 70%+ up to 1981 o Corporate income tax rate: 46%+ up to 1981 >Acceptance of high national debt, and tolerance of budget deficits as a way of managing the business cycle (Keynesian economics) >The "era of easy finance" - Rising tax revenues without the need for legislation increasing taxes, because of -- o Strong economic growth, and o Inflation-driven "bracket creep"

Tax Position Approval Before Filing

Advance Rulings ◦Letter rulings, e.g., tax-free spin-offs rarely proceed without one ◦Advance pricing agreements (APAs) vs disputes under MAPs Real Time Audits - Tax authority and taxpayer agree on tax position prior to return filing ◦US: Compliance Assurance Program (and see OECD's ICAP) ◦Austria: Horizontal monitoring program ◦Italy: Cooperative Compliance program

Alternative Minimum Tax for Individuals

Affecting Many More Taxpayers Than Originally Intended But after TCJA, trend will now reverse (higher exemptions and phase out, plus repealed preference items eg SALT)

the central role of congress

Article I of the Constitution: ◦Section 8: Congress has the power to levy "taxes, duties, imposts, and excises" [plus 16th Amendment authority for income taxes] ◦Section 7: All revenue measures must originate in the House of Representatives [i.e., the Senate cannot initiate tax legislation] House and Senate rules: Revenue measures may be reported only by the "tax writing committees" -- House Ways & Means Committee and Senate Finance Committee ◦Each Committee has a majority party and a minority party tax staff ◦Each Committee member typically also has own tax Legislative Aide

Carbon Taxes Internationally / Imposing the Tax at the Border/ Plastic Taxes

As of 2022, 80% of G20 jurisdictions have already implemented, are scheduled to implement, or are considering a carbon pricing initiative. Moreover, the reach of carbon regulation can be extended beyond domestic activity: the EU Carbon Border Adjustment Mechanism (CBAM), proposed to take effect 1 January 2023, would put a price on the carbon content of sector-specific exports into the European Union (EU), potentially reshaping global trade flows. The CBAM would be in a reporting phase as of 2023; collection of the adjustment is due to start in 2026, although that date may be accelerated. Plastics taxes have been enacted across Europe with varying implementation dates, scopes and compliance mechanisms.

early tax history

Before the American Revolution, British collected revenues by imposing customs duties on trade with its colonies and between its colonies These funds - about 25-30% of British revenues -- financed Britain's administration of the colonies and its military (which protected the trade) The colonies were allowed to set up internal taxation (they mainly used property taxes and poll taxes (fixed tax per adult)) to provide public services Up to 1763, British taxation was only moderately burdensome But Britain developed war debts from Seven Years War with France, and around 1763 steeply increased colonial taxation, especially customs duties Colonists resisted, so high duties were reduced - except for tax on tea... Taxation without direct representation ... and 1776, first shots fired in Lexington

Bright Lines vs Soft Doctrines

Bright line tests provide certainty: ◦Example: A contribution of appreciated property (property worth more than what it cost) to a new corporation is tax-free to the shareholder if the contributions by shareholders result in 80% control (but not 79% control !) IRC 351 But bright lines may offer questionable tax planning opportunities ◦Take example above: What if the property is now worth less than what it cost? Shareholder might prefer to recognize a tax loss, reducing taxable income. So SH can structure contribution so as to receive only 79% control (a "busted 351") US courts evolved "soft doctrines" in response, overriding tax consequences from arrangements that may strictly follow the rules o Substance-over-form / Step transaction / Sham transaction o Economic substance (codified in IRC 7701(o))

supply-demand equilibrium shift

But when taxes are added, the equilibrium price shifts, producing a higher-than- optimal price. This theoretically results in "deadweight loss" to the economy

covid relief

COVID Relief legislation in 2020 was not offset by tax increases or spending cuts. Thus, $3.4 trillion was added to the national debt. COVID relief legislation passed in 2021 added $1.9 trillion more.

Transition Rules and Grandfathering

Changes in tax laws create winners and losers: The question of Effective Dates -Immediate effective date - -Law change applies to income/transactions after date of enactment/announcement -Phased-in effective dates - gradual transition relief -Law change applies to 20% of income/deduction in year of enactment; 40% in year 2; etc -Delayed effective dates - temporary transition relief -Law change applies to income/transactions only X months after date of enactment -Grandfathered effective dates - full transition relief -Law change does not apply to income from investments made prior to date of enactment Or do all taxpayers assume risk that tax laws may change? (Prof. Graetz says yes) Consider transition if tomorrow US switched from income tax to a consumption tax

Annual Accounting Concept

Conceptually, taxing income on a transactional or even lifetime basis may be most fair However, the government must collect revenue on a regular basis so some period for measuring income must be adopted -Since the beginning of the income tax, the government has used a 12-month period The reasons are not entirely clear. Some explanations offered -- -agriculture was a dominant industry at the advent of the income tax -GAAP income statements are typically a 12-month fiscal year, -government budgeting is annual, and -the annual accounting concept was used in other countries successfully

Retroactive Tax Legislation - Courts

Constitutional? Due Process Clause of Fifth Amendment -- US v Carlton, 512 US 26 (1994): (Revenue loss from inadvertent loophole; Congress retroactively changed rule, with change taking effect a year earlier) -Appellate Court ruled law change was unconstitutional because of "reasonable reliance to taxpayer's detriment" §But U.S. Supreme Court overruled the Appellate Court: "Tax legislation is not a promise" -Retroactive rule rationally served a legitimate Congressional purpose, and retroactivity was a rational means to accomplish this purpose -Plus: "Only a modest period of retroactivity" [one year] -Justice O'Connor concurred with a caveat: "The governmental interest in revising the tax laws must at some point give way to the taxpayer's interest in finality and repose. For example, a 'wholly new tax' cannot be imposed retroactively."

Corporate Effective Tax Rates by Country

Corporate effective income tax rate is usually lower than corporate statutory income tax rate, because of the effect of tax incentives for investment, R&D and other desirable economic activity.

Deficits percentage of GDF

Deficits have averaged 3% of GDP for past 50 years -- but now are forecasted by the Congressional Budget Office (CBO) to run much higher in the future

Transparency vs Privacy Interests

Disclosures to the IRS. Examples - ◦"Listed" and "reportable" transactions ◦Tax accrual workpapers, privilege, and Schedule UTP (Uncertain Tax Positions) Disclosure to the public: Presidential tax returns? Corporate tax returns? US GAAP / IFRS explanation of tax rate drivers? Disclosures to other countries? ◦Tax treaties - exchange of information clauses ◦Country-by-country (CbC) reports ◦European Union: Disclosure of cross border tax arrangements in 2019?

Why Should "Uncertainty" Matter ?

Distortion of economic decisions -Whether to undertake an investment -Pricing of investments -Where to locate business operations -Acceleration or deferral of taxpayer actions, e.g., stock sales, repatriation of fearnings The "uncertainty premium": Tax incentives must be made ever more generous (i.e., more expensive to government) to induce the desired changes in behavior, if taxpayers learn to distrust the stability of tax benefits offered Increased burden on tax authorities, e.g., issuance of guidance, training of auditors, volume of taxpayer disputes

Who Bears the Corporate Income Tax Burden?

Double taxation of corporate income: Theory vs Reality ◦Corporations can reinvest profits instead of distribute, deferring 2nd level of tax ◦Much of the shareholder base is tax-exempt (pension funds, charities, foreigners) Corporate tax incidence - Does an increase/ decrease in the corporate taxes cause corporations to -- 1.Decrease/increase compensation paid to employees? or 2.Decrease/increase returns (dividends, capital gains) to shareholders? or 3.Decrease/increase prices charged to consumers? or 4.Some combination of the above? To decide whether a corporate tax change is "progressive", we need to answer this

laffer curve

Economists generally agree that this relationship exists (total tax revenue vs. tax rate) But there is no consensus on the revenue-maximizing tax rate Revenue-maximizing tax rate may differ for labor income versus capital income

Raising Taxes without Tax Legislation, "Bracket Creep" Due to Inflation

Example: Assume simple tax rates and brackets are as follows: ◦Income up to $100,000: 25% ◦Income over $100,000: 35% Assume inflation is 5% per year Assume Taxpayer has income of $100,000 in Year 1. Tax liability = $25,000 •In Year 2, Taxpayer is granted a pay raise of 5%, so income becomes $105,000 •However, Taxpayer's purchases (eg, rent, groceries) cost 5% more due to inflation •Thus, $105,000 can buy only the same goods in Year 2 as $100,000 bought in Year 1 •Taxpayer therefore has had no increase in "real" or "economic" income vs Year 1 Yet, in Year 2, Taxpayer must pay tax of $25,000 plus $1,750 (35% of $5,000)

Vertical Equity - Design Features

Features Increasing Progressivity -Progressive (graduated) income tax rates -Standard deduction and personal exemptions -Refundable tax credits for low or no-income taxpayers, e.g., EITC, child care credit -Phase outs of exemptions, credits and itemized deductions as income rises -Dollar caps on exclusions, credits and deductions Features Decreasing Progressivity -Lower tax rate on income from capital gains and dividends - Itemized deductions disproportionately available to higher income taxpayers -Tax exemption for interest on state and local bonds -Cap on income level subject to tax, e.g., social security payroll tax -Excise taxes, consumption taxes (sales tax, GST, VAT), especially if on necessities

The Joint Committee on Taxation (JCT)

Formed by statute in 1926, the JCT has a staff of lawyers, economists and accountants The JCT is non-partisan and its Chair rotates between the House and Senate tax writing committee Chairs JCT revenue estimates are the official estimates for tax legislation considered by Congressional committees ◦Estimates are for revenue gain or loss within the "budget window" (10 years) Other Duties: ◦Distributional tables - how tax proposals will affect different income levels ◦Publications: Pamphlets on selected tax topics, often as support for hearings

General Anti-Avoidance Rules (GAARs)

GAAR Proposed by the European Commission for the EU: General anti-abuse rule 1.Non-genuine arrangements or a series thereof carried out for the essential purpose of obtaining a tax advantage that defeats the object or purpose of the otherwise applicable tax provisions shall be ignored for the purposes of calculating the corporate tax liability. An arrangement may comprise more than one step or part. 2.For the purposes of paragraph 1, an arrangement or a series thereof shall be regarded as non-genuine to the extent that they are not put into place for valid commercial reasons which reflect economic reality. GAARs widely adopted, e.g., UK, France, Germany, Netherlands, Belgium, Spain, Finland, Canada, China, Singapore, South Africa, Australia, Kenya, India, Italy

national debt

Government debt typically increases during times of major wars or economic crisis, but was in 2019 - in part due to tax cuts -- nearing levels not seen since WW II - despite peace time and a healthy economy. And now, after COVID relief spending, debt exceeds the WW2 high mark of 100%

Income Inequality Trend

Growth in the median household income has not kept pace with GDP growth in past 35 years

Horizontal and Vertical Equity

Horizontal equity: ◦Two similarly situated taxpayers (same ability to pay) should bear same tax burden ◦But what about 2 taxpayers with same income, but different expenses ? ◦Contrast expenses representing choice of consumption (personal gratification) vs non-discretionary expenses (medical, casualty loss?) Vertical equity (progressive vs proportional vs regressive): ◦Higher "ability to pay" taxpayers should bear higher relative tax burden ◦Should the tax system be a tool for income redistribution? Or should we judge fairness only against equitable distribution of the tax burden?

Tax Base Responsiveness

How readily can taxpayers avoid a tax? ◦Mobility of tax base: Compare labor (immobile) vs capital (mobile); income tax (mobile) vs property or consumption tax (e.g., VAT) (immobile) ◦E.g., Cigarette, hotel taxes - if neighbor State has lower or no tax on these? ◦Another factor: How available are planning/evasion opportunities? How readily does behavior change in response to a tax increase or tax benefit? ◦Individual income tax rates: Do taxpayers have the ability to reduce hours worked, or choose not to work at all? (Often, answer is no) Consider inefficiency of tax incentives rewarding behavior that would occur even absent tax incentive, e.g., R&D spending, tuition spending

U.S Treasury Regulation Writers

IRC 7805(a) authorizes Secretary of the Treasury to "prescribe all needful rules and regulations for the enforcement" of the tax laws ◦The Secretary delegates this authority to the IRS Commissioner (in practice, the IRS Chief Counsel's Office owns responsibility) ◦IRS staff coordinate with lawyers in the US Treasury Office of Tax Policy, to work through policy issues US Treasury and IRS publish an annual "business plan" of regulation projects (the "Guidance Priority List")

Streamlining Audits & Dispute Resolution

IRS audit practices & initiatives: ◦"Currency" initiative - don't let IRS agents bog down auditing older tax years ◦Compliance Assurance Process (CAP) - "real time" auditing of current tax year ◦Better planning of the IRS audit: Risk analysis vs "ticking and tying" ◦Large Corp. Compliance (LCC) program: Large corporations selected based on risk profiles Alternative dispute resolution: ◦IRS Office of Appeals - settlements based on probability-of-success-in-court assessment ◦Mediation/ arbitration? Courts: ◦US Tax Court vs US District Courts vs State courts ◦Reluctance of US Supreme Court to take tax cases

What if a Taxpayer Believes US Treasury Regulations Overstep Treasury Authority?

In general, government agencies must follow Administrative Procedure Act •Agency action set aside by Courts only if "arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law." 5 USC 706(2)(A) For a long time, tax regulations were thought to be an exception But in 2011, the U.S. Supreme Court (Mayo) decided that its general test for when a federal agency's regulations were valid (Chevron, 1984) should also apply to tax regulations: •Is the statute ambiguous, after examining text, history and purpose? •If so, was the agency action reasonable, and not arbitrary, capricious?

Most small businesses operate as sole proprietorships

Major source of unreported income •Unlike most wages, such income is not subject to withholding taxes •And only subject to limited 3rd party information reporting

Design Thinking - Innovation Tax Incentive

Market failure: Like education and renewable energy, the private market cost for R&D activity fails to reflect the extra benefit that R&D provides to society -Underinvestment in R&D deprives the economy of positive spillover effects from innovation -Governments can counter this "mispricing" of R&D either by - -providing direct support through spending: Grants and subsidies. (But then the government has to choose the projects - this is problematic), or -providing indirect support through the tax system -Most developed country governments do both

Non-rate thresholds

Married couples pay more income taxes in other ways -- -Medicare & Social Security: -Medicare surtax of 0.9% applies for singles over $200,000, while the limit for married couples is $250,000 -Taxation of Social Security benefits rises as income rises but threshold the same for singles and marrieds -Investment income tax: The 3.8% investment-income tax is paid by singles with income above $200,000, while married couples pay if their income exceeds $250,000 -Cap on deduction for state and local taxes ($10,000) is not doubled for married couples -Earned Income Tax Credit (EITC): Income limits are not doubled for married couples

mandatory spending

Medicare 14% Social Security 24% Medicaid 9% Income Security 7% Other 7% = 69%

Economists' Baseline

No taxes. Absent taxes, capital would flow to sectors of the economy where capital earns the highest rate of return -This allocates investment dollars to maximize national income (i.e., maximizing society's welfare by maximizing employment, prosperity, etc) Taxation introduces distortions - and thus efficiency loss

Expiring Tax Provisions

Numerous temporary tax provisions expire (or are due to expire) each year (in addition to expirations motivated by the Byrd Rule), but regularly extended ◦Example: Renewable energy tax incentives, mine rescue team training credit Why would Congress enact tax provisions on a temporary basis? Bad tax policy? o Opportunity to evaluate effectiveness (revenue foregone vs benefit) before extending -Implies systematic review before extensions, but has not happened in practice o Providing relief in response to economic weakness or natural disaster - or pandemic -E.g., bonus tax depreciation, enhanced casualty loss deduction, residential mortgage forgiveness exclusion o Budgetary reasons -Short term extension loses less revenue in budget window than permanent benefit

Procedural Proposals for Reducing Compliance Costs

Only 2% of U.S. tax return filers file paper returns (98% use tax preparers or electronically file using tax software like Turbotax) Some Simplification Proposals - -IRS could pre-populate returns from W-2, 1099 and other info returns -Free filing software (currently available (FreeFile) but limited access) -Make payroll tax withholding the "final" tax, i.e., no filing required for filers with income only from wages

between the civil war and world war 1

Post-Civil War (1864 - 1890s) -- -Expiration of the income tax (1872), and excise taxes lowered -But tariffs left high: 40-50% on imports (revenue & protectionism) -Until WWI, alcohol and tobacco taxes raised 33% of total federal taxes -Thus, US essentially had a consumption tax system -Aggressive debt paydown, by running government surpluses -National debt as percent of GDP -- 1866: 40% -National debt as percent of GDP - 1893: 4% The 1890s: Recession (Panic of 1893) & rise of progressive liberalism -Industrial revolution, growing monopolies & concentrated wealth, along with regressive consumption taxes → increasing public resentment -Income tax (the 2nd one in US history) enacted 1894: 2% tax imposed on high incomes and corporate profits -Rising support for inheritance and estate taxes: The Jeffersonian principle, "to force each one to rely on his own exertions for his own fortune, desiring to give to all as nearly as practicable an equal start in the race of life." Richard Ely (1888) -But the income tax of 1894 was declared unconstitutional by the US Supreme Court. Pollock v Farmers' Loan and Trust Co (1895): A "direct tax"

Market Failures & Tax Offsets

Privately optimal decisions may not be socially optimal decisions - ◦Production and consumption may proceed to point where individual or firm maximizes private benefits ◦But not to point where society maximizes benefit (or minimizes detriment) Economists call this gap an externality, for which taxation can correct ◦But tax system often undermines efficacy by restricting availability, e.g., tax benefit lost due to AMT, income phase-outs, loss-taxpayers, nonrefundability Two examples: ◦Education ◦Environment/Energy

Byrd Rule

Problem easily arises because -- • Congress often prefers to slowly phase in unpopular tax increases • while accelerating popular tax cuts (e.g., for economic stimulus) • and often relies on one-time (vs ongoing) revenue-raisers Are there ways to work around the Byrd rule? • Longer budget window? •Budget Act 1974 only requires minimum of 5 years (current window is 10 years) •Extend to 20—30 years? (but then also captures growth of entitlement spending) • Sunset tax legislation at end of budget window? •See Bush tax cuts 2001 & 2003 - and the TCJA 2017 (see next slide) and BBBA 2021!

reduced tax burden for the "Middle Class" Since 1980

Reduction in average tax rates over the 30-year period, especially visible with income taxes (vs social insurance taxes)

65+ population growing

Social Security Trust Fund will run out of money soon unless SS taxes are raised or benefits are curtailed (or both)

marginal tax rates

Statutory rate at which the next unit of the tax base is taxed ◦In a progressive rate structure, MTR increases with additional tax base increments ◦Economists believe efficiency loss increases more per each percentage point, as MTR increases

Penalties & Amnesties

Tax Penalties ◦Often a "quick fix" legislative response to publicity about a tax abuse ◦Complicated web of penalties, even after rationalization effort in 1989 Tax Amnesties - "Come forward and pay delinquent taxes by this deadline," and ◦Tax Authority then may offer one or more of the following - ◦Discount on back taxes owed ◦Opportunity to pay in installments over years ◦Waiver of penalties and possibly interest ◦Foreign countries regularly do (Italy has had 60 in 100 years; Brazil 4 in past decade) ◦US federal government has never explicitly offered an amnesty, but States do so

Cost of Complexity: Compliance Burden

Taxpayer costs: ◦Hours spent on preparation and filing of tax returns ◦Dollars spent on paying tax preparers (55% of returns) ◦Studies suggest the above costs are at least 1% of GDP IRS costs: ◦Resources for taxpayer assistance (100M+ calls 2014) ◦Resources for audits and enforcement/litigation

16th amendment

The 16th Amendment to the U.S. Constitution was added in 1913: "The Congress shall have the power to lay and collect taxes on incomes from whatever source derived..." In that same year, Congress enacted the Revenue Act of 1913, and the US has had an income tax ever since Major revisions in 1939, 1954 and 1986. Today's law is called the Internal Revenue Code of 1986

The Concept of "Total Tax Contribution" - Business Taxes Paid Beyond Income Tax

The EBTF 2020 Survey offers an estimated "total tax rate" of 39.8 percent, measuring total taxes borne as a percentage of pretax profitability. That the figure is so much higher than the average European statutory rate of approximately 21 percent tells us much about the prominence of taxes other than the corporate income tax."

Rate Brackets (Marriage Penalty)

The TCJA mitigated the marriage penalty for the lower 6 tax brackets by setting income thresholds for married couples at double that for single taxpayers. But marriage penalty remains for top tax bracket: -A married couple pays 37% on combined income above $600,000, but an unmarried couple pays 37% only on combined income above $1 million ($500,00 each)

Timeline for Tax Reform Act of 1986

The Tax Reform Act of 1986 (the "1986 Act") required bipartisan support because of a divided government (Republican president, Democratic House, and Republican Senate) ◦The Ways and Means Committee conducted 26 days of markup of tax reform; this markup began on September 18, 1985, included some breaks, and did not end until December 3, 1985. The House passed the bill about two weeks after the markup concluded (on December 17, 1985) ◦The Senate Finance Committee reported its tax reform bill approximately four and one-half months after the House passed its version of tax reform. The Senate Finance Committee conducted 17 days of markup; its markup began on March 19, 1986, included some breaks, and concluded on May 6, 1986. ◦After the Senate Finance Committee filed its report for its bill on May 29, 1986, the full Senate deliberated for a little under a month before passing its bill, with amendments, on June 24, 1986 ◦The Conference Committee approved a conference agreement about two months after Senate passage and filed its report another month later (on September 18, 1986) ◦The House and Senate then each passed the conference agreement, which was signed into law by President Reagan a few weeks later (on October 22, 1986)

The Problem of the U.S. Senate Rules

The U.S. Senate operates under rules to protect the minority and open debate ◦Any Senator can speak for unlimited time ◦Senators can propose any amendment to a bill, even if not germane or relevant ◦Any Senator can block any legislation from being voted upon (filibuster, or hold) ◦Only a cloture vote by 3/5 (60) of the 100 Senators can override filibuster -- with exceptions So tax bills frequently resort to a special procedure called budget reconciliation ◦Debate limited to 20 hours ◦Amendments must be germane ◦Only majority (50) of Senator votes required for passage - no filibuster possible

Economic Distortions Due to Taxation

The normal distortion of taxation is magnified when -- ◦The marginal tax rate increases(the last dollar of income is more heavily taxed) ◦The selected tax base is more responsive than alternative tax bases ◦Some investment choices are tax-favored over alternatives ◦Some sources of financing are tax-favored over alternatives ◦Some forms of legal organization are tax-favored over alternatives But economic efficiency increases if taxation compensates for market failure ("externalities"). Such compensating taxes (Pigouvian taxes) can either -- ◦add a tax burden (to raise a cost and thus discourage an activity) or ◦reduce a tax burden (to reduce a cost and thus encourage an activity)

effective marginal tax rate

The rate at which the next dollar of tax base is actually taxed ◦May be higher than the statutory marginal tax rate (e.g., after taking into account phase-outs of deductions and exemptions) or lower (after credits)

statutory tax rate

The tax rates applied to the tax base

Taxes are not neutral

They affect the decisions we make, e.g., ◦when to sell a stock (favorable long term capital gains tax rate) ◦whether to buy a house (mortgage interest deduction) ◦whether to make a charitable contribution (charitable donation deduction) ◦where to locate a factory (location tax incentives) ◦whether to finance with debt (interest deduction) These effects have implications for economic policy and social policy -- policies on which there has never been uniform agreement

U.S. Treasury Regulation - Forms & Types

Three Forms -- 1.Proposed Regulations, followed by comment period and often public hearing. IRS cannot take contrary position on audit. 2.Temporary Regulations - effective immediately and expire in 3 years 3.Final Regulations - often significantly modified from the Prop. Regs Two Types - 1.Legislative Regulations - Congress simply specifies a desired outcome 2.Interpretative Regulations - Congress provides specific rule but leaves ambiguities for US Treasury to clarify (the most common Reg type)

Marriage Neutrality?

Three policy objectives - but only 2 can be satisfied at one time: 1.Marriage neutrality, i.e., the tax system should neither favor or penalize marriage 2.Married couples with the same income should bear the same tax burden (horizontal eq.) 3.Progressive tax rate structure (vertical equity) Marriage neutrality (#1) is sacrificed under our system. We have either - 1.Marriage Bonus, or 2.Marriage Penalty

average tax rate

Total tax liability divided by taxable income ◦In progressive rate structure, average rate will be lower than MTR ◦Example: Individual taxpayer (joint filer) with taxable wage income up to $600,000 ◦Marginal federal income tax rate - 35% (ignoring FICA/FUTA taxes) ◦Average federal income tax rate - 27%

Income → Consumption: Transition Issue

Transition from Income Tax → Consumption Tax creates a tax on existing capital -Retirees save during lifetime their earnings after income tax is paid, and -Under consumption tax (e.g., a VAT?), retirees spend savings and pay tax again Possible solution: -Permit taxpayers to recover against their consumption tax liability their tax basis existing as of the effective date ? Maybe, but very complex

IRS Audit Strategy

Two Different Priorities for Allocating Enforcement Resources - o Maximize revenue from direct collections? Legislators often view this as measure of "Return on Investment (ROI)" for IRS budget dollars o This means targeting the highest income returns for audit o When Slick Willie Horton was asked in 1951 why he robbed banks, he was surprised and said, "I rob banks because that's where the money is" o Maximize voluntary compliance? o This means spreading audit targets among all levels of income, to send a message to the broader population that audit risk exists for any taxpayer playing the "audit lottery"

Importance of Perception of Fairness

Voluntary compliance system -- highly dependent on perception of fairness ◦IRS average audit rate for individuals: Under 1% of all tax returns Perception Concerns Often Drive Tax System Design Choices: ◦Alternative minimum tax (AMT) - ◦A reaction to 1969 report that 155 high income taxpayers paid no income tax ◦In 2017, 5 million taxpayers paid the AMT - but TCJA significantly increased exemption amount and reduced number of returns subject to the AMT ◦Tax Shelters - 1980s-90s: A driver of the Tax Reform Act of 1986 ◦Multinationals and other large businesses - Paying their "Fair Share" of taxes?

civil war years

Wars are expensive! They require higher tax revenues (and also usually borrowing - selling bonds on which interest must be paid - "deficit spending") -The Northern States (Union) vs the Southern States (Confederacy) -Loss of federal revenues from tariffs on imports through southern ports -New taxes put into action, to supplement tariff revenue (29% of total): -Gross receipts tax on business revenues (25% of total federal taxes collected) -Much higher alcohol and tobacco taxes (rising to 10X production costs!) (11%) -The first income tax, with the first withholding taxes (21% of total taxes) -Federal revenues rose from 2% of GDP to 15% of GDP

budget reconciliation process

Will the tax legislation be revenue-neutral, a net tax increase, or a net tax cut ? ◦The House and Senate Budget Committees assign a revenue target to the tax committees accordingly (e.g., for TCJA, maximum net revenue loss of $1.5 trillion) But to use Budget Reconciliation, there are troublesome conditions: ◦Only one Reconciliation bill allowed per fiscal year ◦Each provision must affect revenues, spending or debt ◦No revenue loss allowed outside the 10-year budget window (the "Byrd Rule") ◦No amendment allowed that causes the revenue target to fail to be achieved Any Senator may object on these points (a "point of order") and 60 votes are then required to override the objection

Automatic Economic Stabilizers

Without policymaker intervention, income taxes can mute extremes of economic cycles: •When economy is strong, income tax liabilities rise and government spending (unemployment programs, food stamps) declines •When economy falls into recession, income and payroll tax collections decline but more households become eligible for government transfer programs - creating fiscal stimulus from higher government spending Congressional Budget Office estimated that during the 2009 recession, this automatic stabilizer effect created stimulus equal to $300 Billion per year from 2009-2012

tax

an involuntary levy, imposed independent of the benefit received, under the police or taxing power of the state

tax gap

nonfiling(9%) + underreporting(80%) + underpayment(11%) = gross tax gap - enforced & other late payments = net tax gap

US vs. OECD

one of the highest levels of national debt and considered a very low tax country

tax expenditures

revenue losses attributable to provisions of the Federal tax laws which allow a special exclusion, exemption, or deduction from gross income or which provide a special credit, a preferential rate of tax, or a deferral of tax liability

Other Treasury Guidance

•Revenue Rulings - if facts similar, all taxpayers can rely •Revenue Procedures (information on procedures) •Notices - issued by Chief Counsel Office, usually urgent basis •Letter Rulings (Private Letter Rulings, Determination Letters) •IRS Publications and Instructions •Internal Revenue Manual

The US is Not the Only Country Reporting Tax Expenditures

•The US is listed in the "Basic" category because its annual reports cover only direct taxes, i.e. Personal Income Tax (PIT) and Corporate Income Tax (CIT) •Canada and New Zealand report on PIT and CIT as well as on Goods & Services Tax (GST) •The other countries also include other tax bases such as property, excise, inheritance or estate, capital gains, wealth, energy and other taxes — although not all these tax bases are covered by all countries

effective tax rate

◦Corporate effective tax rate usually is based on GAAP financial statements: Tax accrual (current plus deferred tax expense) divided by book profits ◦But advocacy organizations and scholars often use customized calculations for their own purposes (cash taxes paid often is substituted in the numerator)

What Factors Drive Uncertainty ?

◦Frequent or temporary changes in tax rules ◦Retroactive changes in tax rules ◦Changes with little notice or opportunity to adjust ◦Poorly drafted and ambiguous tax rules ◦Inconsistent enforcement of the rules by tax authority ◦Inconsistent interpretation of the rules by the courts ◦Inconsistent treatment among States/countries ◦Slow dispute resolution

tax base

◦Income tax base is taxable income (e.g., individual labor income, net capital gain income, corporate income) ◦Property tax base is value of the taxable property ◦Consumption tax base is value of taxable goods and services ◦Estate and gift tax base is value of property transferred at death or by gift, reduced by various exemptions and deductions allowed by law

Static vs Dynamic Scoring

◦Two types of effects from tax changes: ◦Behavioral effects - Example: Increased cigarette tax reduces purchases of cigarettes ◦Economic growth effects - Effect on macro-economic factors such as labor participation and GDP growth ("secondary effects"). Commonly called "dynamic scoring" ◦Until current practice, CBO and JCT include only behavioral effects in official estimates ◦From 2015 to 2018 (when Republicans controlled the Senate), Senate budget rules required "dynamic scoring" (secondary effects) when proposed legislation has significant budget impact (more than 0.25% of GDP - about $45B) ◦This allowed Republican tax cuts for investment and business profits to receive lower revenue loss estimates from JCT (if tax cuts boost economic growth, more tax is collected) ◦But such "dynamic" estimates depend heavily on forecasts of GDP growth and unemployment rates, forecasts more often proved wrong than right

taxes change constantly

◦in a process of experimentation to improve the rules, but also ◦in a tug of war between ideological convictions as political power changes hands through elections - ◦Active (higher spending) vs limited (lower spending) government ◦Tax cuts do / do not pay for themselves through economic growth