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Timestamp: 2015-03-31 05:24:43
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Start Making Sense: April 2014
Gamage, Framework for Optimal Choice of Tax Instruments, part 2
Here is Part 2 of an adapted version of my notes for
yesterday’s session discussing David Gamage’s “A Framework for Analyzing the
Optimal Choice of Tax Instruments.”
2. THE PAPER’S ARGUMENT FOR USING MULTIPLE
Again, the paper suggests using all of a labor income tax,
VAT, capital income tax, wealth tax, legal rules, plus perhaps more (subject to
administrative costs) to address distributional issues. But the argument is based on avoidance costs
– not on how distributional outcomes should relate to underlying “true”
information about, say, individuals’ ability, earnings, savings, or gratuitous
One can explain the paper’s main argument in two
complementary ways. First, suppose that
potentially useful tax instruments tend to have a rising marginal cost of
public funds (MCPF) as we start using them more. MCPF is basically deadweight loss per dollar
of revenue raised, adjusted for the social value or disvalue that is associated
with a given outcome’s effect on after-tax distribution. As you use any instrument more, the ratio of
deadweight loss to revenue will tend to increase. For example, doubling the tax rate may tend
to quadruple the distortion. Likewise,
increasing audit rates, if the potential audits are ranked by expected payoff, means
adding ever less fruitful new targets. Keeping
distribution constant, the aim is to equalize the ratio of deadweight loss to
revenue raised at the margin for all instruments. Second, and more distinctively, the paper distinguishes what
it calls single-instrument vs. multiple-instrument tax avoidance. Here the focus is on taxpayer actions to
reduce tax liability. This could involve,
for example, reducing your labor supply, altering your mix of consumption or
investment choices, or paying lawyers and accountants to work their magic for
Tax avoidance presumably has rising marginal costs per dollar
of tax avoided. For example, working
(and thus earning) just a bit less than you’d prefer, taxes aside is not so
bad, but working and earning a lot less starts to get really painful. Or, the tax planners get the low-hanging
fruit first, but then it keeps getting costlier to avoid the next dollar of tax
With a continuous function for tax avoidance, you keep going
until you disvalue at exactly $1 the cost of avoiding another $1 in taxes. Let’s call that the satiation point.
Suppose there is just 1 tax instrument with a 40 percent
rate on whatever it might be (wages, Haig-Simons income, consumer spending, wealth,
etc.). Any time you lower the tax base
by $1, you save 40 cents of tax. So you
reach the satiation point when it costs you 40 cents (in utility terms) to get
a dollar out of the tax base.
Now suppose instead there are 2 tax instruments, each with a
20 percent rate. Multi-instrument
avoidance reduces them both, so the government’s shift to two distinct tax
instruments has no effect. But suppose
some avoidance techniques work on only one of the two systems. For example, a loss-creating tax shelter works
against the actual income tax, but not against a typical VAT. Then you reach the satiation point at 20
cents, instead of 40.
Where only single-instrument avoidance is feasible, multiple
tax instruments turn tax avoidance into a costly retail exercise, rather than a
cheap wholesale exercise. The result,
less tax avoidance, is unambiguously good within the paper’s assumptions. What is more, absent an offsetting concern
about tax overhead costs, there would be no obvious limit to how many separate
systems this analysis suggests that we should have. In my view, this analysis logically holds together. However, the paper’s interpretation of it as
suggesting more specifically that we should use all of a labor income tax, VAT,
capital income tax, wealth tax, etc., puts me in mind of the following three
(1) Information versus evidence – Note two distinguishable
types of issues in tax system design. First, what is relevant information that should affect tax liability? Second,
how as a technological matter do we get at that information? What evidence can we use to measure it?
By information, I mean something that we want to affect tax liability. Examples might include labor income and, more
controversially, returns to saving. By evidence,
I mean something that we use to get at the underlying information. David cites a paper by Roger Gordon and Soren Nielson that considers a VAT and
cash-flow income tax that are assumed to have identical behavioral and
distributional consequences when accurately applied, but involving different
means of avoidance. You avoid the VAT
through cross-border shopping. You avoid
the consumed income tax by concealing receipts. As is well-known in the tax policy literature, either receipts (sources
of income) or consumer spending (uses of income) can be employed towards measuring
consumption. Gordon and Nielson show
that it’s plausible one would want to use some of each instrument, so that
taxpayers can’t avoid the entire tax along either tax planning dimension.
In this model, the VAT and the consumed income tax both seek
to rely on the same information (i.e. how much was consumed), but use different
evidence. By contrast, a realization-based
income tax, a VAT, and an estate & gift tax (to name three well-known types
of tax system) differ in the information
that they treat as relevant, not just in the evidence they use. The VAT bases liability on consumption, the income
tax aims to reach work plus saving, and the estate and gift tax aims at the
making of gratuitous transfers (which implies underlying work and saving).
right answer as to the extent to which tax liability should depend on these different
types of information. That right answer ought
to be implemented as to the overall
tax system, without regard to separate instruments. (And yes, I recognize that the relevant information
might be viewed merely as evidence of something else still, such as ability or
opportunity or expected marginal utility of a dollar). The mark-to-market
income tax, VAT, and estate & gift tax may also, quite distinctly, use
different types of evidence that invite different avoidance mechanisms. For example, the realization-based income tax
encourages strategic trading (hold the winners, sell the losers). For the VAT, there’s unreported cross-border
shopping. The estate and gift tax
obviously has a slew of avoidance techniques of its own, but also permits the
tax authority to take a one-time in-depth view of everything that the taxpayer has
on hand at death.
Suppose you like the different evidence but not the different
information. For example, you might like
taxing estates as a backup to the income tax (both for fraud problems and the
holding of appreciated assets). But that
would imply a different design for the estate tax than if you actually want tax
liability to depend on bequests as an end in itself.
One last point about information: the existing income tax
deliberately uses some types of information other than about income. Examples include the itemized deductions for
home mortgage interest and charitable contributions, along with the exclusion
for employer-provided health insurance. While
the paper groups these items with other tax avoidance, they are in fact meant
by the policymakers to affect tax liability. In principle, if allowing them is the right
policy, we would want to hold constant when using multiple instruments.
The paper notes that, in practice, such items may often be
bad policy, and that the predilection to use particular ones seems oddly
instrument-specific. For example, VATs
but not income taxes commonly offer reduced tax rates for food.
Is using more instruments likely to increase or reduce the political
tendency to make bad choices regarding the use of information to affect tax
liability? The answer to this question
is certainly far from clear.
(2) What is an instrument? – The paper defines “tax
instruments” as any policy variable that a government might adjust to raise
revenue or affect distribution. Sometimes,
however, “instrument” seems to connote instead formally distinct systems. But you can have multiple instruments in the
same system. An example would be
diversifying income tax audit selection techniques to reflect, say, both omissions
suggested by counter-party reporting and “lifestyle audits” of people who
appear to be doing quite well but haven’t reported commensurate income.
(3) What is tax avoidance? – Taxpayers
may want to reduce reported tax liability whether doing so leads to a better or
worse measure of the true underlying information. Consider, for example, documenting legitimate
business expenses, or making sure that losses will be deductible,
notwithstanding the capital loss limitation, in instances where they truly are
representative of overall economic results (i.e., one doesn’t have offsetting
unrealized gains). In principle, while
taxpayers’ incentive to reduce tax liability may be too “strong” from a social
standpoint (Louis Kaplow has an article on this), the socially optimal
incentive is greater than zero. The
paper’s analysis of tax avoidance is premised on its being “incorrect” (not
necessarily legally, but in relation to underlying information that is of
distributional interest), and the correctness issue makes this more
complicated, raising once again the issue of what information we consider
NYU Tax Policy Colloquium, week 13, David Gamage's "A Framework for Analyzing the Optimal Choice of Tax Instruments," Part 1
Yesterday at the NYU Tax Policy Colloquium, David Gamage
presented the above paper. The following
discussion is adapted from my notes for the session. Part 1 is in this blog post, and I’ll put
Part 2 in the next one.
The paper responds to the “double distortion” literature in
legal tax scholarship which draws the conclusion that distributional objectives
should be pursued entirely through a progressive consumption tax (leaving aside
the use of transfers to address the lower end). Under this view, there should be no other distributional instruments in
the tax system (e.g., no income tax, inheritance tax, or luxury taxes), and no
use of legal rules to address distributional objectives.
The paper, by contrast, argues for using lots of smaller
separate systems to address distribution. For example, it suggests that we might want to use of all a labor income
tax, a VAT, a capital income tax, a wealth tax, and legal rules to address
We’ll discuss (1) the double distortion literature, and (2) the
paper’s argument for using multiple tax instruments to address distribution. [But this post only includes Part 1.]
1. THE DOUBLE DISTORTION LITERATURE
This is a legal literature based on certain economics
literature. Economists may be bemused by
how this legal literature treats this economics literature.
The double distortion literature’s central point is simply
to rebut a particular fallacy. Suppose
we are discussing the choice between an “ideal consumption tax” and an “ideal
income tax.” The consumption tax just distorts one
decisional margin: labor supply. The income
tax distorts two margins: labor supply and saving.
the fallacy involves positing that, by also distorting savings decisions, the
income tax inherently does less to distort labor supply decisions. To illustrate, suppose we are making a
revenue-neutral choice between a 25 percent consumption tax and a 20 percent
income tax. (The income tax raises the
same revenue with a lower rate because its base is “broader.”) Seemingly, labor supply is less discouraged
by the income tax because the tax rate is lower.
This analysis fails, however, if one accepts that a worker
who may save is funding present consumption plus future consumption through his
current labor supply. Suppose that I will
spend some of my labor income this year and some in the future. Whereas the 25 percent consumption tax
imposes a 25 percent excise tax on all consumer goods that I might choose, the
income tax, by reason of its hitting intermediate saving, in effect imposes a
higher excise tax on future consumption goods than current ones. Suppose the effect of the income tax on my
deferred consumption is the equivalent of hitting it with a 30 percent excise
tax. We don’t inherently reduce labor
supply distortions by converting the uniform 25 percent excise tax on
consumption into the equivalent of a 20 percent excise tax on some consumption
and a 30 percent excise tax on other consumption.
To a first approximation, therefore, the income tax merely
layers the savings distortion on top of the labor supply distortion, rather
than imposing it partly in lieu of that distortion. This means that taxing saving would require
some motivation other than the mistaken idea that it inherently permits one to
reduce labor supply distortions.
The famous Atkinson-Stiglitz (1976) article on which the
double distortion literature draws also rules out (by express hypothesis) one
further possible argument for the income tax. It assumes separability between labor and all consumer goods, so that
how much you work in the current period does not affect (among other things) your
preferences between current and future consumption. If separability did not hold, and saving for future
consumption turned out to be a leisure complement while higher current
consumption was a leisure substitute, then one might actually offset some of
the labor supply distortion by taxing future consumption at a relatively high
rate (as the income tax does, although there’s no reason to think it would
supply the optimal rate differentiation). But even if we question separability,
for all we know the relationship between current and future consumption on the
one hand and labor supply on the other might lie in the opposite
direction. Separability is arguably a
reasonable presumption from ignorance, at least until we have some question not
to question it but to think that it errs in a particular discernible direction.
What about other possible motivations for taxing saving? They simply aren’t in the Atkinson-Stiglitz model. And there is no reason why they should
be. A given model can only reasonably do
so much. But possible motivations for
taxing saving might include at least the following:
saving is a tag of high ability. Then we
might want to tax it for the same reason that one taxes earnings (and might
decide to tax, say, height) in an optimal tax model.
(2) Suppose we believe that people make many consumption
decisions on a per-period basis, rather than a lifetime basis. Then current
resources (i.e., savings) may have distinctive current-period distributional
(3) Savings offer a cushion to hide one’s ability by working
less. They therefore undermine the use
of an earnings tax to provide ability insurance, supporting an argument that
they should be taxed.
(4) Suppose that, especially after having read Piketty’s Capital in the Twenty-First Century, we
believe that saving plus inheritance leads to accelerating inequality that has serious
adverse consequences. Then one could
view saving (or at least inheritance) as having significant negative externalities,
like pollution. This provides a reason
to tax saving (or at least inheritance) if we believe that these adverse
consequences outweigh any positive externalities from saving.
(5) Suppose we believe that income taxes will generally be
more progressive in practice than consumption taxes, for reasons of political
economy. If one wants the tax system to
be more progressive within the relevant range, this may motivate supporting income
taxation even if it is otherwise inferior.
Now, all these may be either good arguments or bad
ones. The point of interest in relation
to the “double distortion” literature is simply that it provides absolutely no
ground for evaluating them – nor should it; that isn’t its “job,” which is
simply to address the fallacy described above. Lawyers who think that Atkinson-Stiglitz 1976 is relevant to any of
these questions are mistaken – as I rather suspect Atkinson and Stiglitz
themselves would agree.
(Random digression, reflecting that Atkinson and Stiglitz
can speak for themselves on this point, if they are so minded: Recently I
mentioned to a class that the author of a particular article might disagree with
how his argument was being interpreted. This reminded me of the scene in Woody Allen’s Annie Hall where Woody refutes a loudmouth on a movie line who is purporting
to explicate Marshall McLuhan, by bringing out McLuhan himself, who happens to
be in the lobby. I discovered that almost
none of the students had seen Annie Hall. A canonical cultural reference 20 or more
years ago – as, say, The Godfather
still is – Annie Hall apparently has lost
that status.)
Anyway, back to the double distortion literature. The Kaplow-Shavell stricture against using
legal rules to address distribution addresses the same fallacy. To give this point contemporary policy
relevance, suppose that we are concerned about the effect of CEO compensation
and financial sector returns on high-end inequality. Now, we might have independent regulatory
reasons for addressing CEO pay and financial sector returns. For the former, perhaps their pay often
vastly exceeds the marginal private value of their production because of agency
costs, collusive boards, etc. For the latter,
perhaps financial sector returns often vastly exceed marginal social value because
they reflect front-running, duping customers through complexity and opacity,
If these critiques are correct (and I certainly find them generally
plausible), then we have straight efficiency reasons for addressing CEO pay and
financial sector returns. But the
Kaplow-Shavell double distortion / don’t use legal rules for distribution line
of argument would say: We shouldn’t over-correct, and make CEO pay and
financial sector returns too low, rather than too high, in response to the
distributional effects, even if we strongly dislike those effects. Rather, we should address the distributional
issue purely through the tax system (i.e., with a progressive consumption tax)
so that we don’t create labor supply distortions PLUS (and by no means instead
of) particular distortions in these markets.
Once again, the double distortion argument addresses a
particular fallacy, which is that we can inherently avoid labor supply effects
by targeting narrower areas of high-wage labor. But it does not address other possible arguments for using legal rules
in these two contexts, if (as in the case of the above-noted arguments for
taxing savings) plausible rationales of some entirely different kind are
Teaser for my next post, where I will turn to the particular
main arguments in the Gamage paper: Suppose that over-addressing CEO pay and
financial sector returns through targeted regulation has the advantage of
eliminating the use of tax avoidance techniques that would inevitably hamper
using the distribution system. In
particular, even with a shift from the current income tax to a progressive
consumption tax, suppose that we couldn’t eliminate particular “tax gaming”
tricks that would allow CEOs and financial players to wipe out the intended tax
liability. Then, even if they also separate
have bags of tricks to deploy against the regulatory regimes, we might want to
use the regulatory system after all to do some of the distributionally-minded
work. This would merely involve trading
off the reduction in opportunities for tax gaming against the increase in
sectoral inefficiency and regulatory gaming. But arguably the optimal extent to which we would use the regulatory system,
by reason of this tradeoff, is greater than zero.
Closing comment on the double distortion literature: I’d analogize
the usefulness of Atkinson-Stiglitz (“AS”) in the public economics literature to
that of Modigliani-Miller (“M-M”) in the finance literature, with a twist. MM shows that the choice between debt and
equity is irrelevant to firm value unless there are tax issues, bankruptcy issues,
other relevant regulatory regimes that treat the two differently, or agency
cost / asymmetric information issues. MM
doesn’t show that debt-equity choices ARE irrelevant, given that those issues
may exist. Rather, it shows where we
would have to look in order for such choices to matter. Likewise,
AS doesn’t show that we should only use a (potentially progressive) consumption
tax to address all distribution issues. Rather, it shows us where NOT to look for an argument in favor of using
something else. That clears the decks so
that the analysis can move on to the questions of real interest that remain.
See the news article here on a current legal controversy under the New York State sales tax.
It is probably fair to say that, while as quoted in the article it sounds as if I consider the legal issues closely balanced, in fact I would need very heavy odds to consider betting on the taxpayer. Although I'm not a constitutional specialist, the argument for the state that I describe certainly sounds hard to challenge. In addition, the question of fact under the applicable statute - whether "presentational dance entertainment" of a certain type should count as a "dramatic event" for purposes of a state sales tax exemption - was the subject of prior fact-finding by an administrative judge. Hence, unless demonstrably unreasonable I would assume that it is likely to withstand further judicial review.
The reporter didn't use my joke, which was that it's a sad day when the taxpayer here (read the article to see who it is) couldn't get a state auditor named Saint-Amour to evaluate in person whether its "presentational dance entertainments" were indeed "dramatic events."
NYU Tax Policy Colloquium, week 12: Kim Clausing's "Lessons for International Tax Reform from the U.S. State Experience Under Formulary Apportionment"
This past Tuesday, Kim Clausing presented the above paper. It examines evidence concerning the U.S. states' experience with formulary apportionment for corporate income.
The background is as follows. With the source of income being notoriously difficult to pin down, when earned by a multi-jurisdictional company, two main approaches currently prevail. In the international realm, countries generally use transfer pricing. For example, in deciding to what extent Apple's worldwide income pertains, say, to the U.S. parent as opposed to an Irish affiliate (and is treated as U.S. source as opposed to foreign source), the key question is what arm's length price we should attribute to the hypothetical transaction between the two affiliates. By contrast, when the same issue rises within the U.S. under state and local income tax systems, various formulary apportionment (FA) approaches apply. Under classic FA, the percentage of the national company's income that is treated as arising in-state depends on the extent to which the company's property, payroll, and sales are to be found in-state rather than out-of-state. (Intangible property usually is kept out of the property computation, given the difficulty of assigning it a meaningful location.)
Charles McLure famously showed, in an article some decades ago, that state and local corporate income taxes, when the taxable share depends on FA, resemble directly taxing the apportionment factors. Thus, basing the income measure is a bit like having a property tax - if you locate more property in the state, you owe more, although the details also depend on the amount of overall corporate income. Likewise, using the payroll factor is a bit like taxing in-state employment, and using the sales factor is a bit like having a sales tax.
Recent decades have brought considerable movement at the state level away from using a simple three-factor formula in which all three of the above get equal weight. For example, a number of states double-weight sales, and others only look at sales. This shift reflects pressures of tax competition, and/or arguments made to state legislators based on tax competition, with the idea being that you don't want to lose in-state investment or job opportunities, but that sales are relatively immobile. It also has the effect, albeit crudely and imperfectly, of making states' corporate taxes more destination-based, and possibly also more sales tax-like.
A study of the economic effects of using FA, with or without giving sales pride of place, is of interest given the possibility that a given country, such as the U.S., could revise its international rules to move part or all of the way from transfer pricing to FA. (The U.S. rules already have some formulary elements, however - for example, pertaining to interest expense - and it's also likely true that in practice putting more factors in a given jurisdiction may influence transfer pricing outcomes.) Indeed, Clausing has coauthored an article, with Reuven Avi-Yonah and Michael Durst, arguing for the use of sales-based FA in international taxation.
A couple of earlier papers in the field found that states did indeed get some of the positive effects they were seeking (for example, with respect to employment) when they shifted towards giving sales greater weight in the formulas. Clausing's study, however, finds very little effect apart from revenue loss (which apparently was anticipated). The why of the revenue loss is itself an interesting question, possibly reflecting who converted when and also the fact that lots of sales escape being allocated anywhere under typical state formulas.
The paper's somewhat negative finding arguably suggests that shifting to FA in international tax would prompt only smaller, rather than larger, real tax planning responses. On the other hand, as it recognizes, extrapolating from the state to the international level can be risky. State and local tax rates may be too low to induce much tax planning, especially if it has significant fixed costs, but this clearly need not be true at the international level. On the other hand, it's presumably easier to shift factors such as property and payroll between states in the U.S., as distinct from between separate countries.
Also, if the paper's finding smaller responses than the earlier literature had reflects a change over time, as more and more states altered their formulas, this might be evidence of early mover advantages. That might weigh in favor of a given country's deciding to be the first or one of the first to shift from transfer pricing to FA.
I think of the case for FA as based largely on "costly electivity" - that is, on the hope that forcing companies to make real changes in what they do, as the price of getting more favorable results, will have a favorable ratio of revenue raised to deadweight loss incurred. Whether this hope would be realized in practice would depend in good part on the design of the FA rules, and in particular how they countered various new tax planning opportunities that they might create in lieu of the old ones.
In two weeks, we will return to transfer pricing versus FA as an international tax issue, in connection with a paper by my NYU colleague Mitchell Kane that reflects greater sympathy for transfer pricing in the international realm than I personally can summon up, based in good part on claimed advantages from its being already in place. I've been working ahead as the end of the semester nears, but will wait to address here until that session actually occurs.
NYU Tax Policy Colloquium, week 11: Nirupama Rao's "The Price of Liquor Is Too Damn High: State-Facilitated Collusion and the Implications for Taxes"
On Tuesday, we discussed the above paper, which was our second (the first being Saul Levmore, week 1) to discuss the choice and interplay between "tax" and "regulatory" instruments. The paper concerns the measures states take to limit or control alcohol consumption, often with evident secondary (or should I say primary) aims of empowering cartels and favoring local over out-of-state producers.
Alcohol clearly is a good subject for Pigovian taxation. Drunk driving accidents are certainly the clearest example of negative externalities resulting from alcohol consumption, but not necessarily exclusive. One could also make internalities arguments, especially with regard to young drinkers.
As a theoretical matter, Pigovian taxes are easier to design in some cases, harder in others. An article called "Taxation and the Financial Sector," which I coauthored with Douglas Shackelford and Joel Slemrod, makes the point that the negative externalities imposed by financial firms when they risk failure that may lead to bailout and/or horrendous macroeconomic consequences, are very context-specific and hard to capture accurately in a tax instrument. One institution compared to another, or one state of the world compared to the other, may make all the difference in determining what the tax level ought to be. On the other hand, for carbon taxation that is aimed at global warming, while the overall harm measure may be difficult to nail down, at least we know that all carbon molecules are relevantly the same.
Alcohol arguably is somewhere in the middle. On the one hand, it's true that each unit of wine, beer, or spirits has a determinate amount of alcohol in it. But even sticking to the externalities, it matters who is drinking, as well as how much that person is drinking at the same time. One could imagine a sci fi dystopia in which everyone is equipped with monitors for alcohol in the blood that permits the imposition of personalized Pigovian taxes. But since, in the real world, purchase not consumption of liquor is the occasion for levying the tax, we can't come close to doing that. Thus, moderate drinking that may improve one's physical and mental state is hard to except from the regime that is aimed at drunk drivers and self-destructive alcoholics.
There are some fallback methods available. For example, we (try to) ban under-age drinking. And differential taxes on wine versus beer versus spirits can proxy for the things we'd like to measure directly. For example, if we think that young drinkers tend both to prefer beer and to impose the highest drunk driving externalities, we might for that reason subject beer to a higher tax relative to alcohol content. Not surprisingly, however, the states turn out to view things a bit more parochially. California, with its big wine industry, is very nice to wine. Pennsylvania, with its blue collar tradition that we hear about ad nauseum in every presidential election year, is nice to beer.
Explicit excise taxes on alcohol are mainly federal, and only secondarily (by dollar value) state and local-level, and most experts would probably say that, on balance, and despite the variability that we can't capture very accurately, they are set too low, rather than just right or too high. Arguably this reflects the cultural difference in today's world between alcohol and, say, cigarettes. I would speculate that "sin" taxes which are best rationalized on externalities grounds are highest when the sin is one that "we" don't indulge in - only "they" do. By "we" I mean representative voters, with "they" being the Other in such voters' eyes. Evidently, in the era that led to Prohibition, to some extent there was a view that only "they" drink - "we" don't. Then if you go the Mad Men era, evidently "we" both drink and smoke. Today, however, smoking is declasse while drinking is not. So "they" smoke and let's tax it a lot, but "we" drink so let's not tax it so much.
OK, onto the state regulatory structures that the paper discusses. The front part of its title, "The Price of Liquor is Too Damn High," might more accurately be stated as "The Pre-Tax Price of Liquor is Too Damn High, Albeit That the After-Tax Price Might Conceivably Be Too Low." States do a number of cartelizing things in the market for alcohol sales that end up raising the price. These measures may have Pigovian benefits if they suitably reduce alcohol consumption, and they apparently do reduce it. But doing this through the creation of market inefficiencies means that the Pigovian revenues are either lost in pure waste or handed off to wholesalers who are aided by the state regulators in realizing monopoly profits.
A case in point, and the paper's main focus, is Pennsylvania's "post and hold" regime with lookback. Here's how it works. Pennsylvania has a lot of rules in the alcohol market that at least ostensibly are aimed at protecting small retailers, in particular against the likes of Costco. (In an unregulated market, Costco would likely be able to get a better wholesale price, reflecting either cost-saving from the scale that it offers and/or its exercising monopsony power.)
To this end, Pennsylvania requires wholesalers to state in advance the uniform wholesale price that they will charge to all retailers for one month after the posting. That is "post and hold." It facilitates collusion in pricing between wholesalers, and apparently helps result in Pennsylvania's having significantly higher liquor prices than Massachusetts, an adjoining state without post and hold rules.
"Lookback" is the crown jewel of post and hold, so far as permitting wholesalers to reap cartel profits is concerned. Under lookback, once you have posted your price for the month, you can lower it to match a competitor's posted price. This makes it really attractive to aim high on your Stage 1 price, knowing that if someone undercuts you it won't be a problem, and that, for the same reason, you can't undercut them. Especially with repeat players and monthly posting, this is simply a great device from the standpoint of wholesalers who want to collude in ways that would land them in jail for antitrust violations (or else make sufficient cooperation between would-be cartelizers unstable), but for the state's facilitating role.
Anyway, if the alcohol price would otherwise be too low from a Pigovian-plus-internalities standpoint, higher prices from post and hold plus lookback at least have the virtue of reducing alcohol consumption, conceivably closer to its optimal level. But it's equivalent to the state's converting the Pigovian tax revenues into a combination of handouts to liquor wholesalers plus dissipation through waste. The paper makes this case, in addition to showing (both theoretically and empirically) how post and hold plus lookback operate to raise retail prices for alcohol.
My article on Henry Simons has finally been published
My article on Henry Simons, which I presented at a Florida State University Law Review symposium a bit over a year ago, has finally officially appeared in print. You can find it here.
The abstract goes something like this: "Surely
just about everyone in the U.S. federal income tax field has heard of Henry
Simons, if only for his famous definition of “personal income.” Few may realize, however, that this proponent
of 'drastic progression' in a broad-based income tax was also a self-described
libertarian who generally denounced government economic regulation and was
arguably the chief architect of the pro-free market law and economics
movement at the University of Chicago. This
article provides a brief intellectual history of Simons’ work, aiming in
particular to explain how and why he combined these seemingly disparate sets of
beliefs, and what we may learn from them today."
I must confess I rather like, and enjoyed writing, this article, although it is not quite history and also, as a friend who prefers some of my other work told me, is not as "analytical" as I sometimes might be. This reflects that it's partly a literary enterprise and character study. Posted by
NYU book event regarding my international tax book
I'm very much looking forward to the following event, more fully described here.
U.S. International Taxation by Daniel Shaviro – Monday, April 28th, 12:30 PM to 1:50 PM – Vanderbilt Hall Room 220, 40 Washington Square South:
"Please join us for a discussion of Professor Daniel Shaviro’s current book, Fixing U.S. International Taxation (Oxford University Press, 2014). "Following a presentation by Professor Shaviro of key themes from the book, leading experts in the field will offer commentary. We are thrilled that Martin Sullivan, Chief Economist at Tax Analysts (publisher of Tax Notes), and Professor Itai Grinberg, Georgetown University Law Center, will join us. We will also save time for a question-and-answer session with the audience."
At the event, the NYU Bookstore will be offering copies of the book for sale at a 20% discount. I suppose inscriptions aren't out of the question either, should any demand for them materialize. Later the same day, Sullivan will also be giving a talk on a topic of general interest to our audience, most likely pertaining to recent developments in the tax reform process. I will post that here when it's up officially.
UPDATE: Sullivan's 6 pm talk at NYU Law School on Monday, April 28, will have the title: "Tax Reform 2017: Incremental or Fundamental?"
NYU Tax Policy Colloquium, week 10: Susannah Tahk's "The Tax War on Poverty"
(April 8), Susannah Tahk of the University of Wisconsin Law School presented the
above-named paper. As noted in an
earlier post, I was forced by external circumstances to fall short of my usual
practice of promptly posting here a discussion of the issues that the paper
raises. But better late than never.
documents and evaluates the rising use of tax provisions to do heavy lifting with
respect to programs that are aimed at aiding the poor. The most important example is the rise of the
EITC, including its refundable element, and the relative decline of direct cash
grants under TANF today as compared to AFDC twenty years ago. There is also the fact that, say, the child
tax credit, while aimed in large part at the “middle class,” is
partly refundable, to the benefit of poor households with children.
use of the income tax system in lieu of direct transfers to pay money to poor
people has potential optical advantages, compared to overtly using the transfer system –
although it’s less clear to what extent these optical advantages are weakened, once one
makes the payments refundable. And of
course 2012’s “47 percent” meme reflected a related part of the optical downside of formally netting
transfers against income tax payments.
A broader issue –
especially if refundability is inevitably limited and if there is some optical
lean in the "income tax system" towards using exclusions and deductions rather than fixed-percentage, refundable
credits – is that it may be hard to use this means when directing significant transfers to people on the
very bottom. Plus there is the vexed question – central to
the anti-poverty debate – of what role work should play in the design of the
programs, not to mention household structure such as number of kids. These issues arise no matter what formal system one uses.
Suppose we had a
uniform demogrant for all U.S. individuals, financed through explicit tax rate
increases that were very limited at the bottom of the income scale. In the typical language of public economics,
this would not reduce “incentives to work,” which depend purely on marginal
rates. But in the typical language of
anti-poverty discussion, the income effect of the demogrant would indeed reduce “incentives
to work.” That is, recipients would no
longer face as dire a threat of privation (including starvation, assuming no other transfers) if they decided not to work.
case where one side or the other in this language mismatch is logically in error – it’s a question of how you want to
use the term “incentive to work,” which depends on what one cares about. This in turn can depend not only on one's underlying normative views but also on empirical assumptions. For example, a pure utilitarian would not care about "rewarding work" or 'helping the most deserving" as an end in itself, but might believe, depending on the empirical evidence, that in practice inducing work was either very important or not important at all (or anything in between).
The EITC is a
sufficiently interesting and important provision to need substantial
consideration all on its own. In one
sense, it’s “anti-insurance.” Suppose that A and B,
both poor, are both seeking scarce jobs. A
succeeds and B fails. A is therefore
better-off than B - not only does he have more income, but they both wanted the job. With an EITC, A is then the one to reap further rewards from government transfer policy. Purely from a static insurance standpoint, this makes no sense.
hand, suppose there are important reasons for encouraging work and “making it pay.” Then the EITC’s
anti-insurance structure can indeed be defended.
picture more complicated still, one really wants to figure out (among other
things) the overall marginal tax rates that actual or potential EITC recipients
face. At the same time that the EITC offers
a large work subsidy, they may also be facing substantial positive implicit tax
rates from the phase-out of various income-conditioned benefits. Then later on, when the EITC begins to be
phased out, the affected taxpayers either may or may not still be facing high implicit
marginal rates from other phaseouts. (These things vary with the taxpayer and by state or locality.)
Anyway, these are
interesting and important issues that merit a lot more time and attention than
I can offer here while catching up on my blog posts in the late stages of a
busy semester. But it was nice to have a session devoted to it - we hadn't done much distribution so far this year.
As usual, I filed early via Turbo Tax. I gave up doing it by hand some years ago, for reasons that include:
(1) Potential alternative minimum tax liability if you live in a high-tax jurisdiction such as New York, California, or Washington D.C. Whether one ends up owing it or not, what a hassle to have to do the computation.
(2) The nightmare of, say, forgetting $100 of gross income until you are almost done. With Turbo Tax, you just enter it and the computer does the rest. If you're preparing your return by hand, any calculation that depended on adjusted gross income has to be redone.
(3) The last time I did it by hand, there was some insane rule for capital gains, such as trivial mutual fund passthroughs, that related to tax rate changes and special rates. The IRS (through Congress's fault, not its own) had to come up with a form that required something like 15 calculations that I recall as being on the order of, "Take 19% of the amount on line 5, and subtract it from 23% of the amount on line 7. Then take the square root of the absolute value of the difference, round it to the nearest integer, and enter it on Line 12."
OK, I am admittedly exaggerating a bit on that one. But only to convey a Deeper Truth. I do indeed recall finding that, even though each calculation was mechanical, it was very hard to avoid an error (and thus to replicate the result) if one was doing very many of them in a row.
Turbo Tax, here I come, I decided - even though I have subsequently learned that this company may not be the world's best-faith political actor.
But not everyone files early, whether with Turbo Tax or not. Yesterday (April 14), as I took a late night flight from California back to NYC, the man seated next to me appeared to be doing a federal income tax return on his laptop. Good thing it wasn't April 15, as our plane was delayed and landed after midnight.
Some tax shelter-related litigation in which I was an expert witness on behalf of the government has just apparently settled. You can see an article discussing the case here.
In the words of the article, the case concerns “Texas billionaire banker Andrew Beal …. [and] relate[s] to Beal’s use of an abusive tax shelter
the IRS calls Distressed Asset Debt, or DAD, to manufacture billions of bogus
tax losses from junk Chinese debt…..
“In a DAD shelter, a U.S. taxpayer forms a partnership with a foreign
owner of non-performing loans and then claims huge tax losses from the
partnership—losses the foreign lenders, but not the U.S. taxpayer, sustained. The DAD technique spread among the wealthy in 2001, 2002 and
2003 after the Internal Revenue Service began a crack-down on better known
abusive tax shelters, such as Son of Boss ….
“In 2004, after the IRS got wind of DAD, Congress changed the tax
code to explicitly bar partnerships from being used to transfer foreign losses
to U.S. taxpayers. Meanwhile, the IRS began auditing existing DAD partnerships,
disallowing all their losses as shams and slapping on penalties…..
“Beal had created four separate DAD partnerships in 2002 and 2003 to
hold non-performing loans made by the Chinese government, with the aim, the
government says, of stockpiling $4 billion in artificial losses to shelter
income. (Even for Beal, whose net worth is an estimated $11.3 billion, $4
billion can offset income from more than a few years.)….
“[In an earlier case, the district court and Fifth Circuit] nixed Beal’s attempt to claim
$1.1 billion in tax losses from an investment of just $19 million in distressed
Chinese debt, finding ... that the partnership was a
sham that should be disregarded for tax purposes. But the [courts] also
ruled that Beal’s acquisition of junk Chinese debt had 'economic substance'
because—and this sounds bizarre if you’re not a tax geek—he had a reasonable
chance of making a real profit, even as he angled to claim big losses. As
a result …. both the district court judge and the appeals panel held Beal
wasn’t liable for any penalties because he had opinions from both a law
and an accounting firm concluding that it was more likely than not that the
partnership ploy would withstand IRS scrutiny. The appeals court called it a ‘close
issue’ ….”
The issue this time around was simply whether Beal should face penalties
for subsequent years’ disallowed deductions from DAD transactions. Returning to the Forbes article:
"The government … has maintained that the
circumstances of Beal’s three other DAD partnerships and in later tax years
might be different—and more penalty worthy.
“Each side had already paid a big name tax professor to deliver an
expert opinion on whether Beal could rely on those ‘more likely than not’ law
and tax firm opinions to escape penalties. New York University Law Professor Daniel N. Shaviro wrote for the government that the
opinions in 2003 and beyond were weaker because they were based on 'factual
premises that had been rapidly losing credibility.' Specifically, they
assumed that since Beal had made profits in distressed U.S. assets, he could
reasonably expect to make money in the Chinese debt— which wasn’t turning out
to be the case. University of Chicago Law School Professor David A.
Weisbach, whose expert opinion helped Beal escape penalties in the Southgate
decision, weighed in again for his side.”
Anyway, this case has now been settled and there won't be a trial.
I haven't posted for nearly two weeks due to family issues that required attention but that are now pretty well stabilized. Within the next couple of days, however, I plan to post concerning Susannah Tahk's paper at the NYU Tax Policy Colloquium last week, Nirupama Rao's paper tomorrow, perhaps the delights of April 15 (though in California at the moment, I e-filed early), some news concerning recently settled litigation in which I was an expert witness, and a book event at NYU Law School later this month. Plus at least one other event at NYU that I'm looking forward to, along with a couple of upcoming appearances in Europe that I have on my calendar.
The problem with saying more at the moment is simply that I find my iPad a bit suboptimal for writing and editing posts, and left my laptop home in order to be more streamlined.
NYU Tax Policy Colloquium, week 9: Andrew Biggs' Public Employee Pensions: Investment Risk and Contribution Risk
Yesterday, Andrew Biggs of AEI presented the above-named paper. (Title at page 1 of the link appears to be different, but it actually is indeed "Public Employee Pensions: Investment Risk and Contribution Risk.")
The paper addresses the funding issues posed by defined benefit (DB) plans for state and local government employees around the country. This issue is a well-known time bomb that will either explode or else not, possibly in the near future, depending not only on what's done but also on the plans' good versus bad luck with their investments, many of which are in risky equity.
Currently the DB plans are estimated, if I recall correctly, to have about $1 trillion in present value of promised future benefits that remain unfunded. However, this is based on discounting future benefits at a relatively high discount rate, which makes them look smaller. The high discount rate (say, 8%, although it varies with the plan) is based on the expected rate of return from fund investments, which often are quite risky.
Given this actuarial convention in making the estimates - which isn't permitted for private sector DB plans that are subject to ERISA - suppose a DB plan is investing its assets at a very safe 2% rate. It will appear to have very high unfunded liabilities, since they will be valued using this 2% discount rate. The plan's managers decide, therefore, to bet the ranch. They shift to very risky investments with an expected return of, say, 8% or 10%. But this is not free money, of course. The market values the underlying assets the same as the stodgy old 2% assets, because these items could hit a home run, on the one hand, or blow up, on the other.
Was this a wise investment choice by the plan? Very possibly not, since the downside would leave it with gigantic unfunded liabilities. But if I understand correctly how things are being done, the shift would cause the plan to appear as if it were much better-funded, because it could now use the 8% or 10% rate to discount its future liabilities. This can both create dubious incentives, and mislead the audience for funding estimates to overlook the risk of the downside scenario in which the pension plan would end up being very short-handed.
The paper focuses on the question of how investment risk should lead us to think about the DB plans' future prospects - in particular, the risk that, if the plan investments do badly, there will either be defaults (or at least unexpected cuts) or a need for greatly increased contributions by workers or employers. In particular, based on a Monte Carlo simulation where assets such as stock are assumed to have an 8% expected return (or lower in one of the scenarios), with a 12 percent standard deviation, it evaluates probabilities for insolvency, required contribution volatility, etc. In particular, it offers parameters for the unsurprising, if disappointing, conclusion that you can't keep current contributions low and use risky assets to juice the expected return without creating significant contribution volatility and default risk. In other words, using riskier assets fails to offer a free lunch in the paper's simulations (although it does of course turn out nicely for DB plans' stakeholders in the set of cases where the investments do well rather than poorly).
The quatrilemma whereby you can't have low contributions, plus long adjustment periods to make up shortfalls, plus low contribution volatility, plus low default risk, is based on presuming that a theory to the contrary that the DB funds' proponents and stakeholders sometimes advance is not in fact correct. This is the theory that mean reversion in stock market returns means that long-term players, such as state and local governments if they can weather the interim storms, actually do get a free lunch in the form of higher expected returns without greater long-term risk.
To illustrate, suppose that we thought the stock market really was pretty much a lock to earn, say, 8% over time. Then, if you can wait long enough, you can capture the higher return without bearing the variability that torments more short-term players. For this to be true, however, periods of lower or higher returns must not be merely diluted, but positively offset. E.g., if the market's been returning only 6% for a while, it's now likely to earn more than 8% for an offsetting period that gets it back on track.
Conceptually, it's as if an honest coin that yielded 5 straight heads is now likely to even things by running more tails for a while. But admittedly the stock market is a sufficiently complicated beast (e.g., given the role played by market psychology) that we can't rule it out as decisively as we could in the coin example. Still, it would require a rather odd market inefficiency that you would expect savvy investors to exploit. (E.g., if the market is due to start earning an unusually high rate of return, the price level ought immediately be bid up to the point where we are back to the normal rate of return.)
I'm certainly open to theories of market inefficiency. But, while this really is not my area, mean reversion does not appear to me to be among the more plausible candidates. (And indeed I gather that Bob Shiller, who has gotten a Nobel Prize for writing about market inefficiencies, does not believe in it.) For now it's just worth noting that, with mean reversion in stock prices or even a little bit of it, the dilemmas (or, rather, trilemmas and quadrilemmas) discussed in the Biggs paper might become at least slightly less binding.
Insofar as the existence of some or any mean reversion in relevant asset prices remains uncertain, I suppose you could say that supporters of the DB plans' current investment strategies and actuarial reporting conventions are taking a risk that they actually aren't taking on as much risk as they seem to be. And even if the resolution of the second-order risk remains ambiguous, we will certainly learn at some point how their first-order risk-taking has come out.