Thinking Outside the Little Boxes: A Response to Professor Schlunk

Herwig Schlunk, in his article, "Little Boxes: Can Optimal Commodity Tax Methodology Save the Debt-Equity Distinction,"' addresses a problem that I think is key to much tax policymaking. The problem, which goes well beyond the debt-equity distinction, is that policymakers are frequently forced to draw lines between essentially similar things, treating them differently for tax purposes. Debt and equity are fundamentally similar methods of financing a business yet are treated differently for tax purposes. Independent contractors and employees are both service providers but are taxed differently. Imputed returns from services and market-purchased services can be very similar but are taxed differently. This line-drawing problem pervades tax policymaking. Schlunk focuses on what he calls the "optimal commodity tax methodology" for drawing lines such as these.2 The optimal commodity tax methodology provides some specific rules of thumb for line drawing based on a particular model of the problem. This methodology, however, is part of a much more general family of theses.3 At its most general level, the thesis is that if we must distinguish between two activities, we should do so in a way that maximizes welfare. The point is that we should not focus on traditional "tax policy" theories, such as the definition of income, horizontal equity, notions of platonic forms of things like debt or equity, or any other nonsense that does not focus directly on outcomes. A slightly more specific thesis is that lines should be drawn to minimize the deadweight loss from the distinction at issue. That is, the focus of line drawing, with some exceptions, should be on the efficiency effects of distinctions rather than the more general welfare effects. IMAGE FORMULA4 The most narrow thesis is that line-drawing problems have a common structure and, therefore, are susceptible to similar solutions. One of the items is inevitably taxed at a higher rate than the other. Taxpayers have an incentive to shift to the low-taxed item and such shifting produces deadweight loss.4 The degree of taxpayer shifting is related to the compensated cross-- elasticities of demand for the two items. Using standard formulas for deadweight loss that key into these elasticities, we can model the choice and solve for the decision that minimizes deadweight loss. At this level, the theory provides a general approach for solving line-drawing problems and ties together areas of law that might previously have seemed quite distinct. The debt-equity problem looks much like the independent contractor/employee problem which looks like the realization/nonrealization problem. The thrust of Schlunk's argument is that lines in the tax law should be eliminated where possible.5 The debt-equity line-the main example in his article-seems senseless to most observers and probably should be eliminated. Even the most enlightened line drawing cannot solve the central problem with the distinction. The same can be said for numerous other taxlaw lines, such as the distinction between capital gains and ordinary income or the distinction between partnerships and corporations. Schlunk's push to eliminate lines in the tax law is surely right, and line-drawing theses at any of the levels described above do not suggest otherwise. We should always be mindful that good line drawing is a band-aid that does not eliminate the deadweight loss from discontinuities in the tax law. The most beautiful line-- drawing edifice cannot stand for long on a rickety foundation. In making this general argument for the elimination of lines in the tax law, however, Schlunk also makes more specific criticisms of line-drawing theories. In particular, Schlunk argues that optimal line drawing leads to path-dependent results.6 Suppose the world starts out with a few commodities and lines are drawn. When new commodities are discovered, their classification will depend on the lines drawn in the first period. …